Mark-to-Market
On this page you will learn about the Mark-to-Market election.
You may also want to check out the companion website: www.mtmelection.com
Mark-to-Market Accounting Decision
The MTM method of accounting is not a decision to be taken lightly.
It can provide a tremendous tax benefit in certain circumstances but may also result in a devastating tax burden as well. Click here to see examples of both.
Under the MTM method of accounting:
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Gains and losses are treated as ordinary gains or losses - NOT capital gains or losses
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There is an adjustment required to the stock basis of the recognized but unrealized gain or loss on stock
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Gain/income is not subject to self-employment tax
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Reported on Form 4797 Part II
Two major restrictions now disappear:
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The $3,000 net capital loss limitation
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The wash sale rule
So much for the overview, now for the details.
Jump to:
MTM Prerequisites
In order to elect MTM accounting, an option trader must actually be classified as a “trader” as opposed to an “investor.” See the Investor vs Trader page for further information on this delineation.
Section 475 of the Internal Revenue Code (IRC) is entitled “Mark to market accounting methods for dealers in securities.”
Under IRC Sec 475(f), MTM is for a person who is engaged in a trade or business as a trader in securities who elects ...
So three distinct criteria exist:
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A trade or business must exist (see Entities for more on this topic)
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One must be classified as a trader in securities (see Investor vs Trader for more information), and,
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One must make an election to use MTM accounting
Sec 475(f) continues ...
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[an electing person] shall recognize gain or loss on any security held in connection with such trade or business at the close of any taxable year as if such security were sold for its fair market value on the last business day of such taxable year, and
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any gain or loss shall be taken into account for such taxable year.
Thus, if the trader in securities elects to do so, he will be:
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deemed to have sold any security held at year end,
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gain or loss will be determined based on the difference between the fair market value at the close of business on the last day of the tax year and the trader’s cost basis, and
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that gain or loss will be recognized and reported on the trader’s tax return.
Making the MTM Election
The election is effective for the year in which it is made and all subsequent years unless revoked. The revocation request must be made to the IRS and is only valid if approved. We will discuss the revocation procedure below.
The election must be made by the unextended due date of the tax return for the year before the year the election is to be effective.
What?
Let’s look at an example which will hopefully make this clear.
Hal is actively trading stocks and believes he can generate significant income by trading, on a regular and continuous basis, the short-term fluctuations in the stock market, either by using stock or option strategies. In May 2023 he begins trading full-time.
Hal qualifies as a trader in securities but can he make an election to use the MTM method of accounting for 2023?
The answer is NO! Hal would have had to:
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File an election by April 15, 2023 with his 2022 tax return (Form 1040), or,
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Attach the election to his 2022 extension (Form 4868)
What can Hal do?
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Make an election for 2024 anytime until April 15, 2024
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Form a new entity, transfer the securities into the newly formed entity and make a MTM election for the newly formed entity by the 15th day of the third month the newly formed entity is in existence
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Request a private letter ruling (PLR) from the IRS - very expensive and probably unsuccessful
So what does the election actually state? Here is some sample language:
TRADER IN SECURITIES ELECTION TO MARK-TO-MARKET
Taxpayer hereby elects under IRC Sec 475(f) to use the mark-to-market method of accounting for securities. The election will first be effective for the tax year ended [20##]. The election is made for the following trade or business: [name of trade or business, EIN of trade or business]
Taxpayer does/does not have an Applicable Financial Statement as that term is described in Regs Sec 1.475(a)-4(h).
Taxpayer agrees to provide all information, records and schedules pursuant to Regs Sec 1.475(a)-4(k).
This election is attached to the tax return or extension for the tax return year before the year for which the election is to be effective, per the above example. SSN is formatted ###-##-####; EIN ##-#######.
So the election for 2024 is attached to the tax return or extension for 2023.
But Wait, There's More ...
In the above example, Hal has been a trader for a while. Since this is not Hal’s first year as a trader, he will need to file Form 3115 Application for Change in Accounting Method.
Also, a Section 481(a) adjustment is necessary. A Sec 481(a) adjustment is the accumulation of all adjustments arising from a particular change in accounting method in order that items of income or expense are not omitted or duplicated.
Sec 481(a) adjustments, if positive, and so elected on Form 3115, may be spread out over four years. If negative, the entire amount may be taken in the year of change.
Section 481(a) is a technical code section and a complete and thorough discussion is beyond the scope of this website. You would be prudent to seek professional tax advice.
The MTM Election template may be used in order to calculate the amount of the 481(a) adjustment as well as year-end and subsequent year-end MTM adjustments.
So you wanted to make the MTM election but forgot to attach the election to your tax return.
There are a few things you can do.
1. Has the due date of the tax return passed? If not, send a letter to the IRS office where your tax return will be processed. You can look this up on the IRS website The letter should be short and formal: "Taxpayer inadvertently omitted the election under IRC Sec 475(f) from the timely-filed Form 1040 for 20##. That election is included with this correspondence and should be made a part of the Form 1040 referenced. We apologize for any convenience." Sign and include the MTM Election. Make sure to place your SSN/EIN on the cover letter and mail it CERTIFIED MAIL.
2. Did you know about the MTM Election before you filed? If not, stop trading now!! Use the approach described above to make your election. Document that you have stopped trading with your brokerage statement for the month. This will probably set the stage for seeking Regs Sec 9100 relief in similar fashion to the Vines case where the petitioner in Tax Court (Vines) stopped trading thus establishing the fact that the government was put in no worse position. This may work if you catch your error within a few weeks or a month after the filing deadline.
3. Did you receive incorrect or no advice from your tax preparer? If so, again, stop trading now and follow the steps in #2 above. More than likely you will end up seeking Regs Sec 9100 relief, which is described in the next topic.
4. Is it before June 30? If so, you might consider setting up a new entity and making the MTM Election within the first 2-1/2 months of the formation of the entity. You will need to attach the election to the first year tax return for the entity and perhaps file Form 3115 if you are transferring securities into the entity. See this page for more information. And by the way, there is nothing magic about June 30 but you want to have time to trade as a MTM trader during the year to make the new entity and election worth your while.
Note: Relief under Regs Sec 301.9100(3) is requires a user fee. As of this writing, that fee was $12,600. You will probably end up in Tax Court which will cost a small fee plus the fees for the attorneys and CPA, so your tax savings should be substantial.
Relief for a Late Election
The MTM election is fairly straightforward, especially when an example of a timely election is provided. However, missing the election can have disastrous results.
But help has arrived ...
An extension of time to make the MTM election is explained under Reg Sec 301.9100-3 as one of those “any other” elections that are not specifically addressed in other sections.
Under this Regulation, two conditions must be met:
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The taxpayer acted reasonably and in good faith, and
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If the position of the government will not be prejudiced by the granting of relief.
There are several interesting points regarding the two conditions.
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The taxpayer is specifically prevented from using hindsight as a justification for making the election, which makes sense given the procedures for making the election. So, are the procedures actually fair in light of a rapidly moving market?
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The government’s interest is prejudiced if the election is made for a closed period, which again makes sense, but also if the election results in a lower tax liability, and, isn’t that the whole point?!
Therefore, given these conditions and restrictions, relief is available, but it is an uphill battle. Preparing the application for relief is a detailed effort and, as always, must be signed under penalties of perjury.
My recommendation ... let a tax professional prepare this for you. The IRS scrutinizes MTM elections carefully, so you are already “behind the eight ball” in that you are assuming you qualify as a ‘Trader in Security’ plus making a MTM election to reflect substantial losses and you have missed the election … Not exactly a good start.
It has been successfully argued. Take a look at the Vines case.
One More Option (no pun intended)
If you want to elect MTM treatment, setup another trading entity and make a timely election for it. For a new entity, you must make the election by the 15th day of the third month - or basically within 2½ months.
No formal statement must be made to IRS in order to make the election. The election is made during a board of directors meeting and placed into the minutes of the meeting. Then the entity marks to market all securities at year-end.
It would be a good idea to attach the election/board meeting minutes to the timely filed tax return for the first year. Make sure the election is dated before the 15th day of the third month of the new entity’s existence.
Revoking the MTM Election
The revocation process is exactly the opposite of the election process. Instead of a MTM Election being filed, a Notification Statement is filed. The revocation notification must be included with an original tax return or extension for the tax return immediately preceding the desired year of change. For example, a MTM trader wishes to revoke the MTM election in 2024. The Revocation Notice must accompany the tax return for 2023 or the extension filed for the 2023 tax year, filed 4/15/2024. No extensions are permissible except in limited circumstances.
If granted, another Form 3115 must be filed for the year of change, in the example above that would be the 2024 tax return. However, a Sec 481(a) adjustment would not be necessary since the MTM trader would have properly adjusted any open positions during the final MTM year to fair market value and recognized that adjustment on the final MTM tax return. Thus, the new basis would be the adjusted basis from the final MTM tax year.
Once the MTM election is made on a timely filed tax return or timely filed extension, you are proverbially “stuck with it.” You cannot simply fail to file Form 3115 or use other non-compliance techniques to cry “Kings X.” You can be charged penalties for willful failure to comply.
REQUEST FOR REVOCATION OF MARK TO MARKET ELECTION
[Taxpayer Name] hereby requests revocation of the Mark to Market election under IRC Sec 475(e) and to change its method of accounting to a cash basis (realization) method.
The year of change begins 1/1/20## and ends 12/31/20##.
Taxpayer is currently trading [equity and option] securities under the Mark to Market method.
The above is only sample language if not using the downloaded Revocation Request.
Other Revocation Issues
The Notification Statement, again, is attached to the tax return or extension for the tax year immediately preceding the year of revocation.
Further, the Notification Statement should also be attached to Form 3115 filed with the tax return for the year of change. Thus, in the example used above, Form 3115 would accompany the tax return for 2023 with a copy of the Notification Statement attached.
The revocation must designate whether the MTM trader is revoking the MTM election for securities, commodities or both.
You cannot have requested a revocation of the MTM election in the previous five years.
Audit protection does not apply to the revocation of the MTM election.
Also, if a taxpayer requests a change from the Mark to Market election to the cash basis (realization) method of accounting - that of an investor - the change is NOT automatic and a user fee may apply.
NOTE: I have not included any examples of this revocation - Notification or Form 3115 - since this occurs so infrequently among retail traders.
Implementing the MTM Election
So you have made the MTM election according to the procedures detailed above. Now what?
Let’s say you made the election timely with your 2022 tax return filed on April 15, 2023. The election is therefore effective for the 2023 tax year.
Jan 1, 2023 - Calculate the adjustment for the beginning of the year by completing the 481(a) adjustment spreadsheet. If the adjustment is negative, it must be taken in 2023; if the adjustment is positive but less than $25,000 it must be taken entirely in 2023; if the adjustment is $25,000 or greater, then the adjustment may be spread over the next four years, including 2023.
During 2023 - Trade the account as a “MTM Trader in Securities” making note of the new basis in the shares open as of Jan 1, 2023.
Dec 31, 2023 - Use the MTM spreadsheet to calculate the market value of the open securities in your account. Any differences in the market value and your cost basis results in a taxable transaction.
April 15, 2024 - File 2023 tax return with MTM status as a “MTM Trader in Securities.” Do not report gains and losses on Form 8949/Schedule D nor investment expenses on Schedule C. Report trading gains and losses, including the gains and losses resulting from the MTM year-end adjustment on Form 4797, Part II (possibly Form 6781 as well) and the trading expenses on Schedule C and possibly Form 8829. You will also need to file Form 3115 Change in Accounting Method showing the Sec 481(a) adjustment which is the mark to market of the prior year (2022 in this case) open positions.
Download an example Form 3115 here.
Note: The difference between “MTM Trader in Securities” and “Trader in Securities” is simply for reporting purposes. A “Trader in Securities” is subject to the same trading criteria described in the Investor vs Trader section of this website.
If during this period you decide not to continue as a “MTM Trader in Securities” you have two alternatives open to you:
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Request revocation from IRS, or
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Setup a new entity and transfer your entire trading account into the new entity (most practical method of revocation)