New IRS guidelines clarify mark-to-market rules.

With the heightened trading activity of the stock market in recent years, many individuals, particularly the so-called "day traders," may find it advantageous to elect the mark-to-market method of accounting for their trades. This means that traders will have to recognize their gain as ordinary income, which is not as detrimental as it sounds (most of the gain would be short-term capital gain). The real advantage of using mark-to-market accounting is that traders can claim losses as ordinary losses, and can be freed from concerns about the wash sale rule, constructive sale rule and straddles.

In Rev. Proc. 99-17, the IRS recently issued guidelines to clarify some of the rules for electing the mark-to-market method. These guidelines affect dealers in commodities as well as traders in securities or commodities.

As a result of the Taxpayer Relief Act of 1997, traders in securities or commodities are permitted to elect mark-to-market treatment (which is required for dealers). The effect of the election is that traders pay tax at ordinary rates and include in income gains and losses not yet realized. They can carry losses back for two years and forward for 20 years as net operating losses. Once traders make the market-to-market election, however, it is permanent, unless the Service consents to revocation.

Partnerships, as well as individuals qualifying as traders or commodity dealers, may benefit from making a mark-to-market election when trading generates short-term capital gain and ordinary income. They would not benefit if it generates long-term gain or substantial unrealized income.

Traders can identify securities held for "investment" excluding them from mark-to-market treatment, which preserves any potential income (or loss) as "capital" instead of "ordinary" and pay tax only when they are disposed.

To make a mark-to-market election for a tax year beginning after 1998, a taxpayer must attach an election statement to his tax return for the tax year immediately preceding the election year filed without an extension. Alternatively, a taxpayer can attach a timely filed extension request for the preceding year.

This will effectively prevent the taxpayer from looking back at year-end and retroactively deciding to use mark-to-market treatment if losses were sustained during the year. The election statement must describe the election being made and the first tax year for which it is effective. For traders in securities or commodities, the statement must also include the trade or business for which the election is being made.

Prop. Regs. Sec. 1.475(c)-2 prohibits the use of mark-to-market or lower-of-cost-or-market accounting for any nonfinancial customer paper, unless it is supposed to be marked to market as inventory.

The proposed regulations also address the issue of exempting securities from mark-to-market treatment. The IRS stated that exempting specific investments from being marked to market would require clear and convincing evidence that the security was not connected to the trader's business. "Because of the fungible nature of certain securities, the proposed regulations provide a special rule for identifying securities held other than in connection with the electing trader's trading business when the electing trader also trades other of the same or substantially the same securities" notes the Service.

Dealers in securities or commodities (as well as traders in securities) must identify nondealer investments on the day the investment was acquired, and the investment must be held in a separate account. Moreover, unless the IRS issues further rules to the contrary, commodity dealers also cannot exempt from mark-to-market treatment any commodity derivatives they hold.

FROM JONATHAN SCHMELTZ, CPA, NEW YORK, NY