Two weeks ago, I again this year addressed the ugly issue of wash-sale calculations for active traders. Last week's article introduced one way some traders change their trading patterns in December or January in an attempt to avoid those wash-sale calculations. This week's article introduces a more permanent solution but one with some drawbacks.
This series of articles reprises one that I wrote last March. Introducing it earlier this tax season seemed a better idea. That provides more time to ask tax professionals about the ideas introduced in these articles. While I'm on the subject of questioning tax professionals, I want to reiterate that I'm not one. The topics discussed in this series of articles are meant to alert you to topics to discuss with your tax professional, not to give advice.
If you've read the previous articles, you know that there's some confusion, even among IRS employees, about the interpretations of some of these aspects of reporting your taxes. I'm always surprised each year to learn that some traders don't know anything about the wash-sale calculations. Neither, apparently, do some of the accountants who have been calculating their tax returns.
Some traders find a permanent solution to those troublesome wash-sale calculations. They elect the mark-to-market method for accounting for their trades. That permanently erases the need for wash-sale calculations. None are needed. Ever.
However, making that election is fairly permanent, too, so traders need to know it's the right choice for them. It's not always easy to choose mark-to-market status, and it's nearly impossible to undo it, according to several sources. IRS Publication 550 sets forth the standards for this election. If you're considering electing the mark-to-market accounting choice for 2007, you must file a statement with the IRS saying that you want to do so for the 2007 year by April 17, 2007. You would attach the statement 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 you should include in that statement.
There's a problem in updating this article for the 2007 tax year, however, and in advising you right now to consult Publication 550. As of 12/28/2007, the IRS says, "The 2007 revision of Publication 550 . . . has been temporarily removed from www.irs.gov. We regret any inconvenience this may cause and will post the revised version as soon as it becomes available."
Obviously, new revisions are being considered. I knew that there had been complaints that some revisions had not been completed and that some taxpayers might see their returns delayed this year as a result. I didn't know that those revisions involved this publication. All I tell you is what existed as of the 2006 tax year and alert you that changes may be afoot. The article's focus isn't impacted. That focus was to let you know what you might need to check out with your tax professional and not to give specific advice.
Some publications warn that once traders have elected the mark-to-market status, the IRS seldom lets them change that election. Doing so might require setting up a new account and a new trading business in order to change that election, some publications warn. Verify whether this works to change that election with your tax professional. Whatever that tax professional tells you, it's obvious that traders need to be sure that the mark-to-market accounting method is right for them before they submit that statement to the IRS.
In addition to removing the need to ever perform wash-sale calculations again, the mark-to-market method changes the way taxes are reported in a way that's beneficial for some traders and not for others, or it did up through the 2006 tax year. All trading-related gains and losses are reported as ordinary income and losses rather than capital gains and losses. According to the sources I consulted, that means that all losses can be deducted against other income in the year they're incurred rather than limiting you to $3,000 in a single year. 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. You might end up receiving a refund for those previous two years.
Another difference, the one from which the name "mark to market" election derives, is that any securities held at the end of the year are treated on paper as traders have 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. Trading books are effectively closed on the year and then opened the next year with that same trade. In the words of the IRS on the 2006 publication, "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 account, 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 the year."
As good as it sounds to get rid of wash-sale calculations forever and deduct all losses in the year they occur, there's a problem with the mark-to-market accounting method for some traders. Under Section 1256 of the IRS code, all capital gains on broad-based indices such as the S&P 500 or its options are split 60/40 long-term/short-term, regardless of how long or short a period they are held. Sixty percent of the gains are considered long-term gains and taxed at a more favorable rate than the remaining 40 percent, even if you held those options only minutes. Some other securities, such as bonds, commodities or currencies fall under the section 1256 rule, too. The instructions accompanying the 2007 version of IRS Form 6781 list the following as Section 1256 contracts: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options or dealer security futures contracts. The instructions go on to list some special rules applying to "certain foreign currency contracts." You can find the form and the instructions at http://www.irs.gov/pub/irs-pdf/f6781.pdf
However, when traders elect mark-to-market status, they lose that favorable split. Traders who trade a lot of equity stocks or their options might not care; traders like me care a lot. I trade options on broad-based indices almost to the exclusion of anything else. I'd lose that 60/40 split that I get on almost all my trades. Taxes on long-term trades are much more favorable than on short-term ones, so I want that split.
When you're making that decision, you want to know which indices qualify as Section 1256 trades and which are considered narrow-based indices. The IRS sets forth those rules describing the various types, of course, but I certainly couldn't find anything more descriptive. I'm sure it's buried somewhere deep in the IRS code, and your tax professional should know them.
Other sources offer more concrete examples, if they can be trusted. For example, another source says indices 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 weight, 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). On that link, last updated on November 21, 2007, you can find a listing of indices and their classifications as either broad-based or narrow-based indices. If you last checked such listings several years ago, you may be surprised to find more indices listed as broad based than was previously true.
Gains and losses from Section 1256 securities are reported on IRS Form 6781 rather than on a Schedule D. You'd be surprised how many active SPX and OEX traders don't know that. As noted in previous articles, various sources offer conflicting information as to whether traders must detail each trade on that IRS Form 6781 as is done 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 that form, without any need to document each trade. Pretty nifty, huh?
The problem is that many brokerages, and maybe even most of them, don't include options trades on 1099s. The instructions accompanying IRS Form 6781 says that you should "[l]ist separately each transaction for which you did not receive a Form 1099-B or equivalent statement." That includes the 2007 version.
If your brokerage doesn't include options trades on your 1099s, you're going to need to consult a tax professional to decide whether each trade needs to be listed separately. I did list each last year. Perhaps that was overkill according to some sources, but when the IRS says "list separately," I list separately.
Section 1256 securities do share something in common with the mark-to-market accounting election. Section 1256 securities must be marked to market at the end of the year. A Cornell Law School website defined 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." The instructions accompanying IRS Form 6781, the 2007 version, say, "Under these rules, each section 1256 contract held at year end is treated as if it were sold at fair market value (FMV) on the last business day of the year."
It says something else that's music to an active SPX, OEX or other 1256 contract trader's ears: "The wash-sale rules do not apply." Yippee!
This mark-to-market requirement for 1256 contracts does not relate to the accounting method you choose. Despite the similarities in names and the need to mark to market certain trades, electing the mark-to-market method for accounting for all your trades is a separate consideration from the need to mark to market your Section 1256 trades. Make sense? I didn't think so, but I didn't write the IRS code, so I can't be blamed.
It should be obvious that traders and their tax professionals should do some
thinking about the types of trades that predominate in traders' accounts and
whether the benefits of electing mark-to-market status outweigh losing that
favorable 60/40 long-term/short-term split. Next week's article will bring up
another topic that should be considered: whether electing the mark-to-market
accounting method is the only way to obtain the right to deduct trading-related
expenses. As I've noted
the last few articles, if you can't wait until the
completion of this series, you can go back to the original article from which it
is reprised for information on the last topic to be discussed. That article can
be found at