How MTM Works
MTM is a procedure performed at year-end, when a trader marks all open positions to market price. It functions like the accrual method of accounting on the tax return. In essence, the trader is calculating the sale of all open positions at year-end, using year-end market prices. Then, on the first day of the new tax year, the trader inputs the buy-back of those positions at the same market price. The result is that the MTM election converts unrealized positions to realized positions so that the trader can report those gains and losses on their tax returns. As the MTM election does not apply to a trader’s business expenses, a trader may chose to elect MTM for reporting trading gains and losses, but use the accrual or cash method of accounting for reporting qualifying business expenses.
The Tax Benefits of MTM
The advantage of classify MTM trading gains and losses as ordinary gains and losses for a trader is that trading losses may be deducted in full against any type of income (ordinary, capital, passive, investment, etc.) reported on your tax return. Other advantages for the trader choosing the MTM election include:
- The $3,000 limitation on deductible capital losses does not apply.
- Net operating losses (NOL), created by ordinary trading losses, can be carried forward to offset future income.
- NOL can be carried back 2 years to offset prior year’s income and allows a trader to obtain a refund of taxes paid on income in previous years, or they can elect to skip the NOL carryback and carry forward the NOL for twenty years.
- Deferred losses on wash sales are fully deductible against gains.
- Arduous recordkeeping requirements related to wash sales are reduced.
- The procedure for separating and reporting investment profits from trading profits is easier.
Who Can Benefit?
Traders can benefit from using the MTM election allowed under IRC Sec. 475. Taxpayers with current year-to-date losses benefit, as do new traders who have yet to establish a proven record of trading. If you were a trader who experienced both very profitable and unprofitable years because of market volatility, then opting for MTM would prove beneficial.
Trading entities, including LLCs, corporations (C and S), and partnership can elect MTM accounting, and reap the tax benefits. Futures traders could also benefit from ordinary loss treatment under MTM, but would sacrifice the lower 60/40 tax treatment on subsequent years.
Electing MTM Status
The filing procedure for the MTM election is extremely important. If not filed in a timely manner, or if you make any mistakes, the IRS will likely deny ordinary loss treatment, with no excuses entertained and no relief allowed. While taxpayers who miss the deadline could pursue a 6-month MTM extension procedure through a private letter ruling (PLR), the process is expensive and the IRS has denied the majority of previous requests. Therefore, if there is any doubt about if you qualify, whether you should take the MTM election, or how to file for it, promptly contact a qualified trading tax specialist who can assist you.
The three-step procedure for electing Section 475(f) MTM is outlined as follows:
1. Make a timely election in the current tax year by the filing deadline of April 15th (March 15thfor C corporations and S Corporations).
2. Verify that you have indicated the correct application of the MTM election on tax returns filed on time.
3. File Form 3115 (Change of Accounting Method), and an IRC 481[a] adjustment, with the regular tax return filing (in duplicate). See Exhibit 4.1
If filing for the MTM election in the current tax year (and for future years), you will need to attach a statement to your prior year tax return or extension, and send it (certified mail) by the due date of your prior year’s tax return. For instance, if electing MTM for 2010, attach the selection statement to the 2009 tax return or extension and file by April 15, 2010.
Filing Form 3115
Exhibit 4.1 shows a completed Form 3115, Application for Change in Accounting Method, except for the calculation relating to the Sec. 481 (a) adjustment. Traders making the MTM election on Form 3115 need to calculate a Sec. 481 (a) adjustment. A Sec. 481(a) adjustment is intended to report the accounting effect of changing your accounting method. If a trader elects the MTM accounting method for the current year, he or she needs to start their accounting on January 1stwith all open positions valued at market prices on January 1st.
The Sec. 481(a) adjustment is the unrealized gain or loss in a trader’s trading account at the end of the prior year. In other words, it is the difference between the cost of the securities owned at the end of the prior year and the market value on January 1st. If the Sec. 481(a) adjustment is greater than $25,000, traders are required to prorate the adjustment on their income tax return over four years. The full 100 percent is deductible in the year of change if the Sec. 481(a) adjustment is negative.
Tax Tip: By setting up a new business entity and electing MTM accounting through your internal corporate documents, you are able to begin using the MTM accounting method immediately as long as you qualify for active trader status. This is huge. As you recall, an individual must elect and apply for a change in accounting method to MTM on their previous year’s tax return. If you forget to do this, you must wait another year or request an expensive private letter ruling, which most likely will not be favorable.