If you don't know what a wash sale, Section 1256 trade or market-to-market election is, you need to figure it out right now. The IRS expects you to know about wash sales and Section 1256 trades, and it's not going to clue you in on the possible benefits of the mark-to-market election unless you go searching for the information yourself.
You get the disclaimer right up front. I'm not an accountant or a tax attorney. This article is not meant to provide tax advice, but rather to warn you when you might need to seek the advice of such a professional.
First, the wash-sale rule. The wash-sale rule was created to make the lives of active traders as miserable as possible.
Not really. It just seems that way, of course. It did to me when I calculated my taxes after my first year of trading. I discovered that, mathematically inclined as I was--once being able to handle nuclear physics with aplomb--my brain was tied up in knots performing all sorts of convoluted calculations. That happened because that first year, I had concentrated my trading on one company's options. It turns out that if you sell and take a loss in a stock or an option you've held and then buy back "substantially identical stock or securities" within 30 days, you can't take that loss (IRS Section 1091. Loss from wash sales of stock or securities). You have to roll that loss into the cost basis for the repurchase. When you're an active trader, you can imagine the headache this might cause, especially when you go through one of those inevitable periods of one losing trade after another.
The headache gets worse. Imagine what might happen with the calculations if you don't always sell and then buy back the same number of shares or option contracts. For example, imagine that you owned 1000 shares of MSFT and sold them at a loss. On day 2 after that, you bought back 300 shares of MSFT and sold them for a gain. Then, on day 4, you bought back 1000 more shares, but sold them at a loss that same day. You folded 7/10 (700/1000) of the original loss into the cost basis for that day 4 purchase. When you're ready to buy 500 shares of MSFT again on day 5, you will have to fold 1/2 (500/1000) of the day 4 losses into purchase of the 500 shares. Your Schedule D can end up having more branches than the most complicated of family trees.
"Aha," you're thinking. "I trade options, and I'm always buying different strikes." Uh-uh.
Remember that "substantially identical" clause from the IRS code? Other language and legal interpretations of that code clarify that it doesn't matter what strike you're buying, you're going to have to use wash-sale rules if you're dealing in options on the same underlying. One day, you can buy a deep-ITM call on MSFT and take a loss, and then 20 days later, you can buy a far-OTM call on MSFT, and you're going to have to follow wash-sale rules and fold that original loss into the cost basis for the purchase of the far-OTM call on the second purchase.
Stinks, doesn't it? Options traders know that we're not buying something "substantially identical," but don't argue with the IRS.
The convoluted mathematics prove cumbersome, but some have found ways around that. One method is to use software that makes those calculations for you. Many use Turbo-Tax (R), but some people have reported that Turbo Tax's (R) wash-sale computations fall apart when you're buying and selling different amounts of stock or options contracts. That's not something I've verified for myself, so don't take my word for it before you reject Turbo-Tax (R) for these computations. Another software that I'm investigating for my personal use is TradeLog, found at www.armencomp.com.
So far, I can report that the software proved so easy to download that I accomplished that task, uploaded my brokerage account's activity sheet for the entire year, and produced a Schedule D-1, complete with wash-sale computations, all in the time my husband was showering. What I can't yet verify is that all the computations are accurate, as I've just produced that Schedule D-1 as I was drafting this article and haven't gone through all those wash-sale computations line by line. I can, however, verify that trader support is wonderful with this group. I asked a question and the tech support changed the program to meet my need and had it ready for me to reload within an hour. I don't think I've ever had another trade-related software support staff that provided service like that! Furthermore, the support staff says that you shouldn't spend more than 15 minutes trying to import your trades or reconcile your 1099's before calling them for support. Support is free.
If you're interested, the site provides a 30-day trial, but it limits the upload to 20 records. That's understandable, since otherwise, everyone would sign up for the trial this time of year, run their tax forms and not sign up for the full service. If you want to try the trial, upload a batch of records that would include a wash sale.
I sound like a commercial again, and some subscribers do not like any mention of specific software, but others appreciate learning about other traders' experiences with software that might or might not be helpful to their trading experience. I have no connection with this company other than my connection as a paid (and brand new) subscriber.
Of course, you can also pay an accountant to do these wash-sale calculations for you, but don't assume that your accountant knows about wash-sale rules. Through the years, I've talked to several traders whose accountants have been filing their reports for years and not making any wash-sale rule calculations at all. Make sure your chosen accountant understands these calculations.
A third hope is that your brokerage calculates these for you. Mine doesn't. It defers me to TradeLog and several other software sources, including GainsKeeper's software, which also reportedly automates wash-sale calculations and downloads them directly from the account. When I tried GainsKeeper many years ago, it did not properly recognize options trades, but that was at least six years ago. I suggest that, if you're examining several potential software sources, you check this out for yourself, as the company was reportedly working on providing bookkeeping for options traders when I tried them many years ago.
Many of these software programs also allow you to export the forms that you've compiled into popular tax-preparation software such as Turbo-Tax (R). TradeLog's documentation warns, however, that Turbo-Tax (R) may not be able to handle the complicated wash-sale calculations necessary if you're an active trader who trades different amounts each time. TradeLog offers suggestions for handling this problem, but warns that there is no true workaround since the problem lies with Turbo-Tax (R). Again, this is not a problem that I can verify.
Available software programs such as these allow you to perform wash-sale rule calculations with some ease, but you still might have a problem. If you trade straight through the year and into January, trading the same security every few days, and have a loss toward the end of the year, buying that security back again within 31 days, you're not going to be able to take that loss. The wash-sale rule forces you to roll it into the basis for the January trading you're doing.
That can be painful. That can be doubly painful if you've had a losing year in which you're trading constantly, losing frequently, so that one wash sale blends into another right through the end of the year, into January. If you have had that kind of year, you won't be able to take the loss that you've incurred that year, at least not that year.
What's even worse would be if you had a winning spurt the first of the year, but end-of-year losses wiped out the gains from earlier in the year, and you keep trading in and out of that security every few days right through the end of the year and into January. In that case, wash-sale rules might result in all your losses being delayed until the next year while you pay taxes on your purported gains for the year, the gains you accrued the first of the year!
Do you see why I said at the beginning of the article that wash-sale rules were created to make the lives of frequent traders as miserable as possible?
Don't panic as I did when I first heard about the wash-sale rule. The loss isn't gone, as I somehow believed after hearing about the rule the first time. It is rolled into the basis for the next year's trades. You are taking it.
Is there any way around the wash-sale rule entirely? Yes, and I'll discuss that tactic later, after discussing a couple of other quick-fix tactics various articles have suggested. I've heard these ideas batted around for many years, and Armen Computing Ltd. also discusses them on its website. First, if you have losses in December, some websites advise you to avoid buying back the same security for 31 days. For example, if you have been trading MSFT almost exclusively this year and take a loss sometime in December, this work-around suggests that you not buy MSFT again for 31 days. You can trade. Just trade something other than MSFT.
Another suggested tactic is to close out any open positions that have wash-sale losses attached to them by the end of the year and don't buy back that security again for 31 days. The 31 days don't have to begin on December 31. You can close those losing positions December 14, for example, and then buy them back 31 days later.
Here's a question that troubled me, however, when first reading about these tactics many years ago. Did getting out of all positions with wash-sale rule losses attached to them at the end of the year and not buying them back for 31 days mean that I could just list my trades for the previous year in matched pairs and not do all those wash-sale rule calculations? Since no wash-sale losses were being carried over into the next year, the gains and losses figures would be identical whether all those complicated computations were made or not. An article suggested that the wash-sale computations wouldn't need to be made.
However, I'm a stand-up kind of woman or maybe just a cowardly woman, and I wanted to make extra, double sure that this was okay with the IRS. I called the IRS. The IRS representative to whom I spoke proved less than helpful when I asked whether, if I took a December vacation from trading, if I had to do all those complicated wash-sale computations for any losing strings I'd had earlier in the year. Could I just list the transactions as normal on my Schedule D? "I guess you could do that" and "that sounds okay" were the answers. That was far from satisfying. However, since I knew I was paying the proper tax, I attached a note to my Schedule D noting the details of my conversation and did not include any wash-sale rule computations. I would recommend that you talk to an accountant, a tax attorney, or, perhaps less satisfyingly, call up the IRS and ask them before adhering to the hesitant confirmation I received when I called the IRS all those years ago.
Another way to avoid the whole wash-sale rule computations is to elect the mark-to-market method for accounting for your trades. This is more than a quick fix. No wash-sale computations are needed. Ever. In addition to doing away with the wash-sale rule accounting, the mark-to-market method treats all your trading-related gains as ordinary income and losses rather than capital gains and losses. That method also allows you to deduct all your losses in the year they're incurred rather than limiting you to $3,000 in a single year, and you can even carry losses back two years, if you have no other income that offsets that loss, amending the previous two years' tax returns. Who knows? You could end up getting a refund for those previous years.
Another difference, the one from which the name derives, is that any securities held at the end of the year are treated on paper as if you've closed them out and then bought them back at the beginning of the next year. They're marked at the market price that last day, so that your trading books are effectively closed on the year and then opened the next year with that same trade. I don't want to be putting words in the mouth of the IRS, so I'll quote from IRS publications on the mark-to-market method of accounting for your trades:
"A trader in securities or commodities may elect under section 475(f) to use the mark-to-market method to account for securities or commodities held in connection with a trading business. Under this method of accounting, any security or commodity held at the end of the tax year is treated as sold (and reacquired) at its fair market value (FMV) on the last business day of that year."
It's not always easy to elect mark-to-market status. With some exceptions, it's too late to do so for 2006, for example. According to IRS Publication 550, if you'd wanted to elect the mark-to-market method for 2006, you would have had to file a statement with the IRS saying that you wanted to do so by April 15, 2006. If you're considering it for 2007, you would have to file a statement with the IRS saying that you wanted to do so for the 2007 year by April 17, 2007. The statement should be attached to your individual income-tax return or to a request for an extension of time to file that return, if that's what you're doing. Publication 550 sets out the requirements for what must be included in that statement.
Some believe that electing the mark-to-market accounting method also confers more rights to deduct trading-related expenses. However, I'm not certain about that. Being able to deduct all trading-related expenses such as charting programs, books, subscriptions and seminars depends on qualifying as a "Trader in Securities," and, as far as I can ascertain, that's a separate consideration from the election to use mark-to-market accounting methods. The IRS quote above does include the phrase "in connection with a trading business," so I'm on shaky ground, but I'll discuss my reasoning.
IRS Topic 429 (http://www.irs.gov/taxtopics/tc429.html) sets forth the qualifications a trader needs to meet to be considered a "trader in securities," able to take those deductions. They include substantial trading activity, an effort "to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation," and a regular and continuous carrying on of your business as a trader, among others.
If you meet the standards for a trader in securities, sometimes difficult to prove to the IRS, the Topic 429 sheet allows for both mark-to-market accounting methods and the more typical method. It goes on to explain that the "tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election . . . to use the mark-to-market method of accounting." It continues to explain what method would be used if that election had not been made.
So does electing the mark-to-market accounting method automatically confer status as a "trader in securities" or does the trader have to meet the other standards the IRS sets out for that qualification, before deducting trading-related expenses? I don't know. Check this out with your accountant or tax attorney. Or, if you used to be proficient at deciphering Greenspeak, you might try reading the IRS publications for yourself. Perhaps you'll be able to muddle through them and come to appropriate conclusions. The link at http://www.irs.gov/taxtopics/tc429.html includes lots of information, and it's actually clearer than most of the descriptions found in IRS publications.
However enticing that mark-to-market status might sound, traders should be aware of some elements of this election. First, once you've made the election, it's difficult to undo it. Some literature suggests that, since the IRS seldom lets traders go back to regular accounting methods, traders would have to set up a new account and a new trading business in order to do so. Verify this with your accountant or tax attorney. Whatever you learn, it's apparent that electing mark-to-market status should be given serious consideration before proceeding.
Some traders rush to this election, not understanding another aspect of this election, one that's especially important to those who trade the broad-based indices as I do and as many others who trade credit spreads a la Mike Parnos do. Under Section 1256 of the IRS code, all capital gains on these broad-based indices, such as the S&P 500 or its options, are split 60/40, with 60 percent of the gains considered long-term gains, and taxed at a more favorable rate, and 40 percent being considered short-term gains. However, when you elect the mark-to-market method, all gains are taxed as ordinary income, and that favorable split is lost.
Since I trade the broad-based indices almost exclusively, I've chosen not to elect the mark-to-market method because I would lose that favorable split, but if you're trading a lot of equity stocks or options, or options on narrow-based indices, you might not make the same choice. This information should be verified anyway with . . . you guessed it, your accountant or tax attorney.
Which indices qualify for that Section 1256 trades and which are considered narrow-based indices? The IRS sets forth rules describing the various types, of course. One source says an index would be considered narrow based if they "contain nine or fewer component securities, if a single component security comprises more than 30 percent of its weighting, or if the aggregate of the five highest-weighted component securities comprise more than 60 percent of its weighting" (www.twenty-first.com/exchange-traded_index_options.htm). That link also provides a listing of indices and their classifications as either broad-based or narrow-based indices. Rules appear to have been changed or clarified in November of last year, and some indices that previously were not considered broad-based ones now are, at least according to that www.twenty-first.com link. For example, the SOX was not previously considered a broad-based index, I don't believe, but the site now lists it as one. Some other securities, such as bonds, commodities or currencies fall under the Section 1256 rule, too, according to www.armencomp.com.
Gains and losses from Section 1256 securities are reported on IRS Form 6781, rather than Schedule D. I've read conflicting information about whether you need to detail each trade on that IRS Form 6781 as you do with a Schedule D. Most sources note that the gains and losses are taken straight from your brokers' 1099s and plugged into the appropriate lines on IRS 6781. Then the 60/40 split is made as directed on the form, without any need to document each trade.
However, many--and maybe most--brokerages do not include options trades on 1099s, and the instructions accompanying the IRS Form 6781 state that that you should "[l]ist separately each transaction for which you did not receive a Form 1099-B or equivalent statement," so I would quibble with the advice that each option trade wouldn't need to be listed separately. Once again, however, I'm not an accountant or a tax attorney and my interpretation could be wrong.
Whether you're considering the mark-to-market method of accounting for your trades or anticipating qualifying for status as a trader of securities or doing neither of these, you need to know that all Section 1256 securities must be marked to market at the end of the year. This Section 1256 requirement does not relate to the accounting method you choose. It doesn't matter which accounting method you've decided upon or whether you meet the qualifications for a trader of securities or any of that. This requirement relates to the type of security you trade. Despite the similarity in names, electing the mark-to-market method for accounting for your trades is a separate consideration from the need to mark to market your Section 1256 trades.
A Cornell Law School website defines a Section 1256 contract and also suggests that such a contract would be "treated as sold for its fair market value on the last day of such taxable year," if you'd like to read their interpretation. It can be found at http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00001256----000-.html
I once was surprised by some of these considerations, and I don't want our
subscribers to be similarly surprised. These topics are discussed for the sole
purpose of alerting traders to matters they might discuss
and clarify with tax
professionals. I do not claim to be such a professional, and it's possible that
the information here is wrong or outdated. Don't rely on it. Use it as a
starting point for the discussions you need to have with people more
knowledgeable than I am.