Mark-to-market election

A mark-to-market election is a tax choice available under Section 475(f) of the Internal Revenue Code. This election applies to domestic funds Domestic fund A domestic fund is a hedge fund organized under U.S. law—typically as a Delaware limited partnership or limited liability company—that serves as the primary investment structure for U.S. taxable investors. that conduct business as traders in securities or commodities. When a fund makes this election, it must treat its securities or commodities as if they were sold at fair market value Fair value Fair value is the price that buyers and sellers would agree upon in a normal, competitive market transaction. This market-based approach serves as the primary method for valuing hedge fund portfolios under generally accepted accounting principles (GAAP). on the last day of each tax year.

The election creates a fictional sale at year-end. The fund calculates gains or losses based on the difference between the asset's fair market value and its tax basis. These gains or losses are then treated as ordinary income or loss rather than capital gainsProfits realized from the sale of capital assets, typically taxed at preferential rates compared to ordinary income. or losses.

Only funds that qualify as "traders" can make the mark-to-market election. This distinction is important because it affects both eligibility for the election and the ability to deduct various business expenses.

Traders engage in frequent buying and selling of securities for their own account. They conduct this activity regularly and continuously, similar to running a business. Investors, by contrast, buy and hold securities primarily for capital appreciation and income over longer periods.

The trader qualification requires meeting specific criteria related to trading frequency, holding periods, and the intent behind the trading activity. Funds must demonstrate that their trading constitutes a trade or business rather than investment activity.

Section 475 defines "securities" broadly to include many types of financial instruments. Securities encompass stocks, partnership interests in widely held or publicly traded partnerships, debt instruments such as bonds and notes, and various derivative instrumentsFinancial contracts whose value depends on underlying assets, including options, futures, swaps, and forwards.. The definition also includes interest rate swapsDerivative contracts where parties exchange interest rate payments, typically between fixed and floating rates, commonly subject to central clearing requirements., currency swapsA financial derivative where two parties exchange principal and interest payments in different currencies for a specified period., equity notional principal contractsA notional principal contract where payments are based on the performance of equity securities or stock indices., and any hedging positions related to these items.

Similarly, "commodities" include any actively traded commodity, notional principal contractsA financial contract where payments are determined by reference to a notional principal amount and one or more underlying assets or indices, without exchange of the underlying principal. relating to commodities, derivative instruments in commodities, and positions that hedge commodity exposures. This broad definition ensures that most trading positions fall under the election's scope.

Funds can exclude certain securities from mark-to-market treatment under specific circumstances. If a particular security has no clear connection to the fund's trading activities, the fund can exclude it by properly identifying the asset on the date of acquisition.

This exclusion allows funds to maintain some investments as capital assets outside the mark-to-market system. For example, a fund might exclude long-term strategic investments or positions held for non-trading purposes while still applying mark-to-market treatment to its active trading portfolio.

Making a mark-to-market election requires following specific procedural steps and deadlines. Existing funds must file the election by the due date of their tax return for the year before the election takes effect, excluding any extensions.

New funds have more flexibility in their timing. They can make the election for their first year by documenting the decision in their books and records within two months and fifteen days of their initial year. They must then include a copy of this documentation with their original tax return.

The timing requirements are strict, and missing these deadlines can prevent a fund from making the election or delay its effectiveness.

The mark-to-market election converts all gains and losses on covered securities from capital treatment to ordinary income treatment. This change eliminates the distinction between short-term and long-term capital gains, which normally depends on holding periods.

For funds with high turnover rates, this conversion often provides benefits. Without the election, frequent trading typically generates short-term capital gains, which are taxed at higher ordinary income rates anyway. The election simplifies the tax treatment while often producing similar tax results.

Ordinary income treatment also allows losses to offset ordinary income without the limitations that apply to capital losses. Capital losses can only offset capital gains plus a small amount of ordinary income each year, while ordinary losses can offset any type of income.

Funds can end their mark-to-market election by filing a notification statement by the due date of their tax return for the year before termination takes effect, excluding extensions. However, terminating the election creates significant restrictions.

Once a fund terminates its mark-to-market election without IRS consent, it cannot make a new election for five full tax years. This restriction begins with the year the termination becomes effective. This penalty encourages funds to carefully consider the election's long-term implications before making or ending it.

The mark-to-market election simplifies tax accounting substantially and can improve tax efficiency in many situations. Once the election is active, funds typically avoid compliance with wash sale rulesTax rule that prevents taxpayers from claiming losses when they sell securities at a loss and buy substantially identical securities within 30 days before or after the sale. and straddle rulesTax rule that governs the treatment of offsetting positions in personal property to prevent artificial tax losses through the strategic timing of gains and losses.. These rules can be complex and time-consuming to navigate.

The election also eliminates the need to maintain detailed records of tax basis and holding periods for trading positions. This reduction in record-keeping requirements can significantly lower administrative costs, particularly for funds with high trading volumes.

The wash sale rule typically prevents taxpayers from claiming tax losses when they sell securities at a loss and then buy substantially identical securities within 30 days before or after the sale. This rule is designed to prevent taxpayers from claiming tax benefits on transactions that don't represent genuine economic losses.

The mark-to-market election eliminates the need to apply wash sale rules entirely. Since all positions are automatically marked to market at year-end, the timing of actual purchases and sales becomes irrelevant for tax purposes. This elimination removes a significant source of complexity in tax compliance.

Beyond eliminating wash sale and straddle rules, the mark-to-market election removes several other administrative burdens. Funds no longer need to track detailed tax basis information for each trading position or maintain records of holding periods.

This simplification is particularly valuable for funds with complex derivative portfolios or high-frequency trading strategies. These funds often have thousands of transactions that would otherwise require detailed tracking and analysis. The election reduces this administrative work to a simple year-end marking exercise.

Recent proposed Treasury Regulations affect how total return swapsA derivative that allows one party to receive the total return from an underlying asset while transferring the credit risk to another party. are taxed. These regulations require annual mark-to-market treatment for many total return swaps, with value increases treated as ordinary income and decreases treated as expenses.

Funds that already have a Section 475(f) mark-to-market election in place should not face adverse impacts from these proposed regulations. However, funds without such an election may encounter significant unexpected tax consequences when the regulations become final.

The decision to make a mark-to-market election requires careful analysis of the trade-offs involved. The primary benefit is administrative simplification and the elimination of complex tax rules. However, this comes at the cost of converting potentially favorable capital gains treatment into ordinary income treatment.

Funds that expect to generate significant long-term capital gains may prefer to avoid the election and maintain capital asset treatment for their positions. These funds can benefit from lower tax rates on long-term capital gains. Conversely, funds with high turnover rates and frequent losses often benefit from the simplified accounting and ordinary loss treatment that the election provides.

The election also affects how losses can be used. Ordinary losses can offset any type of income, while capital losses face more restrictions. This factor can be particularly important for funds that experience volatile performance or expect to generate losses in certain periods.