Section 475 MTM Accounting
Section 475 MTM exempts traders from capital loss and wash sale loss limitations.
The biggest problem for investors and traders occurs when they’re unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders with trader tax status (TTS) can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or Section 1256 contracts if elected.
The “Tax Cut & Jobs Act” gives a new tax benefit for Section 475: A 20% deduction on qualified business income (QBI) in a pass-through entity. QBI likely includes Section 475 ordinary income, and it excludes capital gains.
Capital loss limitations
By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund from using Section 475 MTM right away?
Section 475 ordinary gain or loss treatment
Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 15 for the current tax year) can’t claim business ordinary-loss treatment on trading losses for the current tax year. They will be stuck with capital-loss carryovers.
A new entity set up after April 15 can deliver Section 475 MTM for the rest of the current tax year on trading losses generated in the entity account if the entity files an internal Section 475 MTM election within 75 days of inception. The new entity using Section 475 does not change the character of capital loss treatment on the individual accounts before or after entity inception. The entity is meant to be a fix for going forward; it’s not a means to clean up the past problems of capital loss treatment.
Ordinary trading losses can offset all types of income (wages, portfolio income, and capital gains) for you and your spouse on a joint filing, whereas capital losses only offset capital gains. Plus, business expenses and business ordinary trading losses comprise an NOL. A 2017 NOL can be carried back two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Starting in 2018, NOLs are carried forward indefinitely, and they are limited to 80% of taxable income. Business ordinary trading loss treatment is the most prominent contributor to federal and state tax refunds for traders. The Act also limits excess business losses over $500,000 (married) and $250,000 (other taxpayers.) The excess loss is carried forward and treated as part of the taxpayer’s NOL applied up to 80% of the subsequent years taxable income.
There are many nuances and misconceptions about Section 475 MTM, and it’s essential to learn the rules. For example, you’re entitled to contemporaneously segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end you can defer unrealized gains on adequately segregated investments. You can have the best of both worlds — ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse TTS and Section 475; they are two different things, yet very connected.
Section 475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals that qualify for TTS and want Section 475 must file a 2018 Section 475 election statement with their 2017 tax return or extension by April 17, 2018. Existing partnerships and S-Corps file in the same manner by March 15, 2018. For the Election statement and Form 3115 filing, see our tax guide below.
For more in-depth information about Section 475 MTM, including many nuances to consider in making or revoking an election, climbing out of a capital loss carryover hole, and much more, read Green’s 2018 Trader Tax Guide.