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Even though it’s too late to elect Section 475 MTM for tax-year 2020, the opportunity for 2021 is available now. In this blog post, I will cover the scenarios that make it prudent to obtain Section 475 for tax-year 2021 and how to make the election.
Before I dive in, let’s review the deadlines, because they are approaching rapidly. Traders eligible for trader tax status (TTS) can elect 2021 Section 475 MTM on securities and/or commodities by April 15, 2021, for individuals and March 15, 2021, for partnerships and S-Corps. (The IRS postponed the April 15, 2021 tax deadline until June 15, 2021, for residents in all counties in Texas after a federal disaster declaration in February 2021. This postponement also applies to the Section 475 election. The delay includes various 2020 business returns due on March 15 like partnerships and S-Corps.)
Why is Section 475 so attractive? It exempts securities trades from wash sale loss adjustments and the capital-loss limitation against other income; which is what I call “tax-loss insurance.” Profitable TTS/475 traders are eligible for the 20% qualified business income (QBI) deduction if under the QBI taxable income threshold (see below).
Who should make the Section 475 election? Capital gains are needed to absorb capital losses, so if you have capital loss carryovers or significant unrealized capital losses on segregated investment positions, the MTM election would be a gamble. If a TTS trader has new trading losses in 2021 YTD before the election deadline, then a 2021 Section 475 MTM election is generally preferred since it allows ordinary loss treatment and does not add to capital loss carryovers.
Existing Individuals and Entities
To make the election, simply write this statement on a sheet of paper with your name and social security number (or entity EIN) up top.
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“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities and not Section 1256 contracts).”
Attach the 475 election statement to your 2020 tax return or extension. (See Tips For Traders: Preparing 2020 Tax Returns, Extensions, and 475 Elections.) If you plan to e-file your 2020 tax return or extension, but cannot include the 475 election statement in the e-filing, then submit the 475 election statement with a cover letter to the IRS before the 2020 tax deadline.
If you want to apply Section 475 to 1256 contracts, revise the statement to include commodities. (Generally, retaining lower 60/40 capital gains rates on 1256 contracts is the better choice.)
The election statement is just the first part of the process — and the most crucial part. You also have to file a timely 2021 Form 3115 with your 2021 tax return in 2022 and fax a duplicative copy to the IRS.
You can revoke a Section 475 election by the due dates in a mirror process.
Section 475 MTM does not apply to duly segregated investment positions (more on that below).
New Entities
The 475 election process is different for a new taxpayer, a newly formed entity, or first-time individual tax return filer. You must place the statement below in your books and records within 75 days of your new entity’s inception (new LLC/partnership or S-Corp). It’s safest to use the date you obtained the employer identification number (EIN).
“Under IRC 475(f), the Taxpayer at this moment elects to adopt the mark-to-market method of accounting for the tax year ended December 31, 2021, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as an entity (for securities only and not Section 1256 contracts).”
A new taxpayer does not need to file a Form 3115 for an internal Section 475 MTM election. The new entity adopts the 475 MTM accounting method from inception.
If you want to include Section 1256 contracts in the 475 election, then revise the election statement to include “commodities” (Section 1256 contracts). This action is wise if you have significant losses in the first 75 days in these contracts.
20% Deduction on Qualified Business Income
The Tax Cuts and Jobs Act of 2017 introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI).
Traders eligible for TTS are considered a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too.
QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income.
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020 and $329,800/$164,900 (married/other taxpayers) for 2021. The IRS adjusts the annual TI threshold for inflation each year.
Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap.
Segregation of Investments
Suppose a trader holds investment positions in equities and trades substantially identical securities positions in equities or equity options using TTS and Section 475. The IRS could recharacterize trades as investments, or vice versa, whichever suits them best. For example, the IRS could reclassify an investment position in Apple equity currently deferred for long-term capital gains into Section 475 MTM ordinary income at year-end. Alternatively, the IRS could recharacterize Section 475 MTM ordinary losses on Apple options as capital losses triggering a $3,000 capital-loss limitation.
Traders with overlap between investing and trading activity should consider ringfencing TTS/475 trading into an entity and conducting their investment activity on the individual level. That solution would fix the potential IRS problem.
Here’s an example: Joe owns an investment portfolio of equities. He leverages his investments using portfolio margining to trade equity options around those investment positions to manage risk on the portfolio and collect option premium. Joe is not selling naked options because he holds equity investments and trades in the same brokerage account. Joe needs to choose between using Section 475 or portfolio margining.
475 Fixes Wash Sales With IRAs For TTS Trades
If there is an overlap in securities traded in taxable accounts vs. what’s invested in IRAs, the trader has to avoid triggering permanent wash-sale losses throughout the year. If a trader takes a loss in a taxable account and buys back a substantially identical securities position 30 days before or after in an IRA account, the loss becomes permanent.
Traders can fix this problem with a “do not invest” list to avoid such overlap. One strategy is to trade equities and equity options in taxable accounts and invest in ETFs, mutual funds, and REITs in IRAs.
TTS traders can make a Section 475 election to do away with wash sales between trades and the IRAs, so overlap is not a problem.
Consider all IRA accounts for married filing joint, including traditional IRAs, Roth IRAs, rollover IRAs, and SEP IRAs. Don’t include qualified plans like 401(k) or solo 401(k) plans.
Most traders are not aware of the nuances of triggering permanent wash sales between taxable and IRA accounts. IRS rules for broker-issued 1099-Bs have a narrow view of wash sales; they call for wash-sale loss adjustments on “identical symbols” for the one account. Conversely, IRS wash sale rules for taxpayers have a broader view: Calculate wash sales on “substantially identical positions” (between equities and equity options) on all individual brokerage accounts, including IRAs. Consider using trade accounting software that’s compliant with IRS wash-sale rules for taxpayers.
Examples
Joe Trader has a $100,000 Q1 2021 trading loss in securities, and he elects Section 475 by April 15, 2021, to offset the ordinary loss against wage income of $150,000. Without the election, Joe would have a $3,000 capital loss limitation against wages and a $97,000 capital loss carryover to 2022. Instead, he used his full trading loss in 2021.
Nancy Trader has a $50,000 Q1 2021 trading gain and annual wages of $60,000. She might be eligible to receive a QBI deduction of $10,000 (20% x $50,000 QBI 475 net income).
Section 475 is a consequential election for TTS traders with many advantages but consider your circumstances and the nuances first. We cover various Section 475 scenarios and more in-depth information on 475 elections in Green’s 2021 Trader Tax Guide (see Chapter 2 on MTM).