Mark to Market Accounting for Financial and Tax Reporting

Mark-to-market accounting is a method of valuing assets based on their current fair market price, providing a real-time snapshot of an asset’s worth. It is used in financial reporting to provide transparency to investors and for specific tax situations governed by the Internal Revenue Service. This valuation method stands in contrast to historical cost, which records an asset at its original purchase price.

The Mechanics of Mark-to-Market Accounting

Mark-to-market accounting involves adjusting the value of certain assets on a company’s financial statements each reporting period to reflect current market value instead of original purchase price. This method is most commonly applied to marketable securities whose values fluctuate with market conditions. The process provides a more current picture of a company’s financial health but can introduce volatility into financial statements if market prices are unstable.

Under historical cost, an asset’s value remains fixed at its purchase price, and a gain or loss is only recognized when the asset is sold. For example, a stock bought for $100 remains valued at $100 on the books until it is sold. In contrast, mark-to-market accounting recognizes changes in value as they happen.

If that same $100 stock increases to $120 by the end of an accounting period, the company reports a $20 unrealized gain on its income statement. This gain increases the company’s reported net income and the asset’s value on the balance sheet, even though the stock has not been sold. This approach offers a more transparent view of an asset’s current economic reality.

In financial reporting under Generally Accepted Accounting Principles (GAAP), historical cost provides stability for assets like property, plant, and equipment. Mark-to-market is used for financial assets like trading securities and derivatives. The choice between methods depends on the nature of the asset and the intent behind holding it.

Elective Mark-to-Market for Tax Purposes

The Internal Revenue Code (IRC) allows taxpayers who qualify as a “trader in securities” to make an election under Section 475(f) to use the mark-to-market method. The tax treatment for traders is substantially different from that of investors. An investor buys and sells securities expecting to earn dividends, interest, or long-term appreciation, and their activity does not rise to the level of a trade or business.

To qualify as a trader, a person must be in the business of buying and selling securities with substantial, frequent, and continuous activity, with the intent to profit from short-term price swings. The IRS and courts look at factors like the holding period of securities, the frequency and dollar amount of trades, and the time devoted to the activity to determine if it constitutes a business.

When a qualifying trader makes the Section 475 election, all securities in the trading business are treated as if sold for fair market value on the last business day of the year. The resulting gains and losses are recognized as ordinary income or loss, not capital gains or losses. This allows an ordinary loss from trading to fully offset other income, such as wages, bypassing the annual $3,000 limitation on deducting net capital losses.

Another benefit is that the wash sale rules under Section 1091 do not apply to an electing trader. The election covers securities such as stocks and bonds, as well as commodities.

Mandatory Mark-to-Market Tax Rules

The use of mark-to-market accounting is mandatory for certain financial instruments known as Section 1256 contracts. These contracts are automatically subject to mark-to-market rules, regardless of whether the holder is an investor or a trader.

Section 1256 contracts include regulated futures contracts, foreign currency contracts, and non-equity options, such as options on broad-based stock indexes. Holders must treat these contracts as if sold at fair market value on the last business day of the tax year. This rule applies to both realized and unrealized gains and losses.

The tax treatment for these contracts is the “60/40 rule.” Under this rule, any gain or loss is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. This split applies no matter how long the contract was held, which provides a tax advantage as the 60% portion is taxed at lower long-term capital gains rates.

This treatment is reported on IRS Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. The rules also feature a loss carryback provision, which allows a net loss from Section 1256 contracts to be carried back three years to offset prior gains from such contracts.

The Process for Electing Mark-to-Market Treatment

A qualifying trader elects mark-to-market accounting under Section 475 by filing a statement with the tax return for the year before the election is to become effective. For an existing taxpayer, this means attaching the statement to their tax return, or an extension, by its original due date. For example, to make the election effective for the 2025 tax year, the statement must be filed with the 2024 tax return by April 15, 2025.

After making the initial election, the taxpayer must also file IRS Form 3115, Application for Change in Accounting Method, with the tax return for the year of the change. Continuing the example, Form 3115 would be filed with the 2025 tax return.

The election statement must specify that the taxpayer is electing the mark-to-market method under Section 475. It should also state the first tax year for which the election is effective and identify the trade or business. Once made, the election is binding for all subsequent years and can only be revoked with IRS consent.

For a new taxpayer, such as a newly formed entity, the rules are different. A new entity makes the election by placing a statement in its books and records no later than two months and 15 days after the first day of its first tax year. A copy of this statement must then be attached to the timely filed tax return for that year.