Section 475 MTM Accounting

TTS traders consider a Section 475 election for tax-loss insurance and a QBI deduction.

Traders eligible for trader tax status (TTS) have the option to make a timely election for the Section 475 accounting method on securities and/or commodities. Section 475 is mark-to-market (MTM) accounting with ordinary gain or loss treatment. Without it, securities traders use the realization (cash) method with capital gains and loss treatment, including wash sale loss adjustments and the annual $3,000 capital loss limitation.

Caution: Sole proprietor (individual) TTS traders who missed the Section 475 MTM election date (May 17, 2021, for 2021, and April 18, 2022, for 2022) can’t use ordinary-loss treatment and are stuck with capital gains and losses and perhaps capital-loss carryovers. Carefully consider a 475 election for 2023 due by April 15, 2023, as you need capital gains to use up capital loss carryovers, and 475 is ordinary income. (We go through the decision-making in Green’s Trader Tax Guide, chapter 2.)

A new entity could deliver Section 475 MTM on trading losses generated in the entity account if it filed an internal Section 475 MTM election within 75 days of inception. A new entity should be in business for Q4 to establish TTS.

Ordinary losses offset all types of income (wages, portfolio income, and capital gains) on a joint or single filing, whereas capital losses only offset capital gains. Plus, business expenses and ordinary trading losses comprise a net operating loss (NOL). The 2020 CARES Act allowed five-year NOL carrybacks for 2018, 2019, and 2020. TCJA allows carryforwards only for 2021 and subsequent years.

By making a 475 election on securities only, TTS traders retain lower 60/40 capital gains rates on Section 1256 contracts (futures), and they can segregate investment positions for long-term capital gains. If there is overlap on securities trades vs. taxable investment positions, consider an entity for ringfencing TTS/475 from segregated investment positions on the individual level.

The 2017 TCJA offers a 20% qualified business income (QBI) tax deduction for pass-through businesses, including sole proprietors. TTS trading is a specified service activity. QBI includes 475 ordinary income, excluding capital gains/losses, portfolio income, and forex. TTS expenses are negative QBI. A profitable TTS/475 trader is eligible for the QBI deduction providing their taxable income is not over the QBI thresholds.

Section 475 election procedures

Existing taxpayer individuals that qualify for TTS and want Section 475 must file a 2022 Section 475 election statement with their 2021 tax return or extension by April 18, 2022. Existing partnerships and S-Corps file in the same manner by March 15, 2022. The second step of a 2022 Section 475-election is to file a Form 3115 with the 2022 tax return.

Revised excerpt from Green’s Trader Tax Guide Chapter 2 Section 475 MTM Accounting