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 (April 18, 2022, for 2022) can’t use ordinary-loss treatment and are stuck with capital gains and losses, perhaps capital-loss carryovers. You should skip a 475 election for 2023, due by April 18, 2023, if you need capital gains to use up capital loss carryovers, as 475 is ordinary income, especially if you have capital gains in Q1 2023. (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 a minimum of 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. 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 NOL carryforwards only starting in 2021 through 2028. 

Starting in 2021, Section 475 ordinary losses are subject to TCJA’s excess business loss limitation (EBL). Losses over the threshold are NOL carryforwards. The inflation-adjusted 2022 EBL threshold is 540,000 (married)/$270,000 (other taxpayers), and the 2023 EBL is $578,000 (married)/$289,000 (other taxpayers).

By making a 475 election on securities only, TTS traders retain lower 60/40 capital gains rates on Section 1256 contracts (futures).

Securities traders can segregate investment positions for long-term capital gains. If there is an overlap in securities trades vs. taxable investment positions, consider an entity for ring-fencing TTS/475 from segregated investment positions on the individual level.

TCJA offers a 20% qualified business income (QBI) tax deduction for pass-through businesses, including sole proprietors. TTS trading is a specified service trade or business, so there is an income threshold and cap. 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.

The QBI taxable income (TI) cap is $440,100/$220,050 (married/other taxpayers) for 2022 and $464,200/$232,100 (married/other taxpayers) for 2023. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for SSTB. The W-2 wage and property basis limitations apply within the phase-out range. The IRS adjusts the annual TI threshold for inflation each year.

Section 475 election procedures

Existing taxpayer individuals that qualify for TTS and want Section 475 must file a 2023 Section 475 election statement with their 2022 tax return or extension by April 18, 2023. Existing partnerships and S-Corps will file similarly by March 15, 2023. The second step of a 2023 Section 475 election is to file Form 3115 with the 2023 tax return.

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