What Is Section 475(f) and How Does the Mark-to-Market Election Work?

Section 475(f) of the Internal Revenue Code allows traders to optimize their tax strategies through the mark-to-market election. This provision enables eligible taxpayers to treat gains and losses from trading securities as ordinary income or loss, rather than capital gains or losses, which can be advantageous in certain scenarios.

Understanding the mechanics of this election is essential for active traders, as it requires adherence to specific procedures and compliance requirements.

Eligibility for the Election

Eligibility for the mark-to-market election hinges on the IRS classification of the taxpayer as a “trader in securities.” This designation applies to individuals or entities actively engaged in buying and selling securities to profit from short-term market movements. The IRS evaluates the frequency and volume of trades, the holding period of securities, and the time devoted to trading activities to determine trader status.

Traders must demonstrate substantial, regular, and continuous trading activity, often involving numerous trades on a daily or weekly basis. Evidence of their trading strategy and time commitment may be required. Partnerships, S corporations, and limited liability companies can also qualify for the election, but the decision must be made collectively at the entity level.

Making the Election

The mark-to-market election process involves specific steps to ensure compliance with IRS rules.

Timing Requirements

The election must be made by the due date of the tax return for the year before the election becomes effective. For instance, to apply the election for the 2024 tax year, it must be filed by the due date of the 2023 tax return, typically April 15, 2024. Missing this deadline forfeits the opportunity for that tax year.

Form Submission

Traders must attach a statement to their timely filed tax return, declaring their intention to adopt the mark-to-market accounting method. Additionally, Form 3115, “Application for Change in Accounting Method,” must be submitted with the tax return for the year the election takes effect. This form requests the IRS to approve the change in accounting method. Consulting a tax professional can help ensure accurate and complete submissions.

Ongoing Consistency

Once made, the election must be applied consistently to all eligible securities in future tax years, preventing selective application. All gains and losses must be reported as ordinary income or loss, based on the securities’ fair market value at year-end. Failure to maintain consistency can lead to penalties or revocation of the election by the IRS.

Calculating Gains and Losses

Under the mark-to-market method, gains and losses are determined by the year-end valuation of securities. Taxpayers calculate fair market value as of December 31st to identify gains or losses, which are reported as ordinary income or losses. Fair market value represents the price a willing buyer and seller would agree upon.

To calculate, compare the year-end fair market value of a security to its adjusted basis, typically the purchase price plus any associated costs. If the fair market value exceeds the adjusted basis, a gain is recognized; if lower, a loss is recorded. This approach allows traders to report gains or losses based on market fluctuations, even without actual sales during the year.

For example, if a trader purchased securities for $50,000 and their year-end value is $55,000, a $5,000 gain is reported as ordinary income. Conversely, if the value drops to $45,000, a $5,000 loss is recognized. This method enables traders to offset other ordinary income, potentially reducing their taxable income.

Classification as Ordinary Income

Under Section 475(f), gains and losses are treated as ordinary income, which affects tax liability. Ordinary income is taxed at the taxpayer’s marginal rate, up to 37% for individuals in the highest bracket. This classification allows traders to fully offset losses against other ordinary income, such as wages or business earnings, avoiding the limitations imposed on capital losses.

Filing Requirements

The mark-to-market election introduces specific filing obligations. Gains and losses must be reported on Form 4797, “Sales of Business Property,” instead of Schedule D, which is used for capital gains and losses. Form 4797 accommodates the ordinary income treatment required under the mark-to-market method.

Additionally, Form 3115 must be included with the tax return for the first year the election is effective. Accurate and timely completion of these forms is critical to prevent delays or issues during IRS reviews. Engaging a tax professional familiar with Section 475(f) can help ensure compliance with all filing requirements.

Recordkeeping Considerations

Accurate recordkeeping is vital for maintaining compliance with the mark-to-market election. The IRS requires detailed records of all trading activities, including purchases, sales, year-end valuations, and adjustments to asset bases. These records support the calculation of gains and losses and substantiate eligibility for the election.

Traders must document year-end fair market values using brokerage statements, market data, or independent appraisals for less liquid securities. Records should include the methodology used to determine fair market value. A complete log of trading activities, including dates, quantities, and prices, is essential for calculating adjusted bases. Retaining copies of all tax returns, forms, and related correspondence for at least seven years is recommended.