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TAX TIME TIPS FOR DAYTRADERS

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http://www.fairmark.com/traders/mtmacc.htm

http://www.taxesfortraders.com/marktomarket.htm

http://www.irs.gov/taxtopics/tc429.html

Mark-to-Market Accounting

By Kaye A. Thomas

Information about the mark-to-market election for securities traders.

Beginning in 1997, the tax law has permitted securities traders (as well as commodities dealers and traders) to elect a method of accounting called the mark-to-market method. Many securities traders will find this election attractive as a way to make filing simpler — and possibly reduce their taxes.

Note: Commodity traders have special concerns that are not addressed in this guide.

Mark-to-Market Election

If you're a trader, you may choose whether or not to make the mark-to-market election. You don't automatically get mark-to-market treatment when you file as a trader. And you can't elect this treatment if you aren't a trader.

The election has to be filed by the return due date — without extensions — for the year before the year you want the election to be effective. The last day to file the election for the year 2004 is April 15, 2004. For guidance on how to file the election, see the following pages.
Consequences of the Election

Marking to market. The most obvious consequence of the election is that at the end of each year you must mark your securities to market. What this means is you treat any stocks you hold at the end of the day on December 31 as if you sold them on that day for the current market value. If the stock has gone down, you get to report a loss without actually selling it. If the stock has gone up, you have to report that gain. Your basis for the stock is adjusted to reflect the gain or loss you report, so that you don't report the same gain or loss again when you actually sell the stock.

For a true day trader, this aspect of the election is of no significance. You don't hold stocks at the end of the day, so you don't hold stocks at the end of the year. Your gains and losses are already in the book. This isn't true for a position trader (a trader who holds positions longer than a day trader). A position trader who makes the mark-to-market election loses the ability to do year-end tax planning by selling losers and holding winners.

No wash sales. The wash sale rule doesn't apply to a trader who has made the mark-to-market election. There's a simple logic to this: if all your gains and losses are going to be flushed out on December 31, there's no reason for the tax law to be concerned about wash sales that may occur during the year.

Wash sales can be a significant headache for a trader even if they don't affect the amount of tax the trader has to pay. If you make hundreds of trades in the same stock, many of the trades are likely to result in wash sales. At some point, accounting for all the wash sales becomes nearly impossible. Eliminating this concern is a significant benefit of the mark-to-market election.

Ordinary income and loss. If you make the mark-to-market election, your trading gains and losses are converted to ordinary income and loss. You'll report the gains and losses on Form 4797 (sales of business property), not Schedule D (capital gains and losses).

This does not mean that your trading gains are now subject to self-employment tax. In a 1998 tax law, Congress clarified that although your trading income becomes ordinary income, it is not self-employment income. This also means you can't use this income to support a contribution to an IRA or other retirement plan.

Traders usually generate all or nearly all of their gains as short-term capital gains, which are taxed at the same rate as ordinary income. In most situations, changing to a system where the trader reports the gains as ordinary income will not have any tax cost. If the trader has capital losses from an investment that isn't part of the trading activity, though, the trader will lose the ability to offset those losses with capital gains from trading.

For many traders, the flip side will be more important. Even good traders sometimes have losing years. When they do, the capital loss limitation rears its ugly head. A trader who has not made the mark-to-market election can deduct only $3,000 of net capital loss, with the excess loss carrying forward only, not back to earlier, profitable years. If you make the election, your trading loss isn't subject to this limitation, and can carry back as well as forward. The difference can be huge.
You're Stuck With It

Once you make the election, you have to continue to use the mark-to-market method for all future years. You can change the election only with the consent of the Internal Revenue Service, and they generally won't grant this consent if your reason for changing is simply that the election didn't turn out to your advantage. Be sure you know what you're doing before making the election.

Part 1 of our explanation of how to make the mark-to-market election.

Many elections under the Internal Revenue Code are as simple as putting a checkmark in the proper box. That isn't the case for the mark-to-market election. In fact, making the election is a royal pain. The following explanation assumes you've already read the preceding pages on mark-to-market accounting and identifying investment holdings.
Deadline

The IRS chose an unusual deadline for this election. Most elections are due at the end of the year, when you file your return. This election has to be made by the due date — without extensions — for the previous year's tax return. The last day to make the mark-to-market election for the year 2011 is April 18, 2011 (the unextended due date for 2010 tax returns).

I believe the main reason for this is to prevent taxpayers from choosing the election at a time when they already know whether their trading activity will generate a profit or a loss. Many traders would wait until they have a year with significant trading losses, then file the election for that year to avoid the capital loss limitation. Of course you're stuck with the election for all future years once you make it, but until then you get the benefit of capital gain treatment in profitable years without worrying about the capital loss limitation in a year with poor results.

There's a rule that says a "new taxpayer" (a taxpayer for which no federal income tax return was required for the preceding year) can make the mark-to-market election during the first two months and 15 days of the election year. They make the election by recording it in their books and records rather than by filing an election with the IRS. It appears that this rule was designed for newly formed entities (such as corporations and partnerships). Individuals who start trading after April 15 without forming an entity will apparently have to wait until the following year to make the mark-to-market election.

Making the Election

Making the election is a two-step process (with the second step being in two parts). The first step is to file an election, on or before the unextended due date of your tax return for the year before the year to which the election applies. If you file your tax return by the regular due date, attach the election to your tax return. If you file on extension, attach the election to your extension request.

Note: You may read elsewhere (as I have) that this election may be filed by itself. The IRS clearly states that the election must be attached to the return or the extension request.

Note: If you filed early you can still make the election if you act by the due date of your return. File an amended return with the election attached.

Here's what an election would look like, assuming it applies beginning in the year 2011 and that it is filed with the original return or with an amended return filed by the unextended due date:
John Smith
SSN 123-45-6789
Attachment to 2010 Form 1040

I hereby elect to use the mark-to-market method of accounting under section 475(f) of the Internal Revenue Code for my trade or business of trading securities. The first year for which the election is effective is the taxable year beginning January 1, 2011.

_____________________
John Smith

Make appropriate changes if the form is filed for a different year or if it is attached to Form 4868 instead of Form 1040. IRS guidance doesn't seem to require a separate signature on this statement but I feel more comfortable if the signature is included.
That's All — For Now

That's all you have to do right now. But you have some special requirements for the following year's return: the return for the first year the election is effective. See the