If You Can’t Deduct All Your Trading Losses Consider Section 475 Election

April 6, 2017 | By: Robert A. Green, CPA


If You Can’t Deduct All Your Trading Losses Consider Section 475 Election

Individuals qualifying for trader tax status (TTS) with a significant trading loss in the first quarter of 2017, should consider a 2017 Section 475 MTM election, due by April 18, 2017. (S-Corps and partnerships had to make this election by March 15, 2017.) Profitable traders should consider the election, too.

Avoid loss limitations including a $3,000 capital loss limitation for 2017, capital loss carryovers to 2018, and wash sale loss adjustments. The Section 475 election converts capital losses into unlimited ordinary business losses, which may generate tax savings immediately. For example, a $50,000 Section 475 ordinary loss offsets wage income without limitation, whereas a capital loss is limited to $3,000 against other income, including wages. I refer to Section 475 as “tax loss insurance,” and it’s one of the most attractive tax benefits for TTS traders. April 18th is the deadline, so make the right decision and act fast.

Here are two scenarios where the election is wise

1. TTS individual trader has trading losses of $50,000 for Q1 2017, comprised of $25,000 losses in securities, and $25,000 losses in futures (Section 1256 contracts). He also has a capital loss carryover of $100,000 from 2016 into 2017.

Starting the year 2017, this trader hoped to generate capital gains to use up his capital loss carryover, figuring the next $100,000 of capital gains is tax-free. But, things went awry, and he generated trading losses in 2017.

Smart move: File a 2017 Section 475 MTM election on securities and Section 1256 contracts by April 18, 2017. It doesn’t make sense adding to a significant capital loss carryover. Next, create an LLC trading company, which files a partnership or S-Corp tax return. That entity may generate capital gains to pass through to the individual level to use up the $100,000 capital loss carryover. If the trading entity incurs trading losses, it can elect Section 475 internally, within 75 days of its inception. Plan to revoke the individual Section 475 election on Section 1256 contracts by April 15, 2018, for 2018.

2. TTS sole proprietor trader has trading gains of $40,000 for YTD 2017 in securities and Section 1256 contracts. She does not have a capital loss carryover or unrealized capital losses, so she has a clean slate for electing Section 475. She also trades IRA accounts, so she faces a potential wash sale loss problem. If she incurs a trading loss in her taxable trading account and buys back a substantially identical position 30-days before or after in her IRA account, she will never get the benefit of that tax loss in either taxable or IRA accounts. That’s far worse than a deferred wash sale loss at year end. (Broker 1099Bs don’t account for wash sales between taxable and IRA accounts, whereas the IRS requires taxpayers to do so.)

Smart move: File a 2017 Section 475 MTM election on securities only, not including Section 1256 contracts, by April 18, 2017. She retains lower 60/40 capital gains tax rates on Section 1256 contracts, with 60% being a long-term capital gain taxed at lower rates. The Section 475 election on securities exempts her from wash sale loss adjustments in her taxable accounts, which also prevents wash sale losses with her IRA trading accounts. If she incurs a significant trading loss later in the year in her taxable accounts, she will be glad to have ordinary loss treatment rather than a capital loss limitation.

Section 475 MTM election statement
Type the below statement on a sheet of paper with your name and social security number (or entity EIN) up top.

“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended Dec. 31, 2017, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not Section 1256 contracts).”

If you want to include Section 1256 contracts, modify the language accordingly. For external Section 475 MTM elections, this is just the first part of the election process – and the most important part. You also have to file a timely 2017 Form 3115 with your 2017 tax return in 2018 (with a duplicate copy to the IRS National Office).

Learn more about Section 475 MTM in Green’s 2017 Trader Tax Guide. There are many nuances, myths, and scenarios to consider.

Section 475 could be an important election for you, so get it right! Don’t be one of the thousands who complain they missed the boat, which sails on April 18th or messes up the process. If you already filed your 2016 tax return or extension, you should send the IRS a letter by April 18, 2017, explaining you left out the election. Consult a trader tax expert, preferably us.