Section 475(f) of the Internal Revenue Code of 1986, as amended, provides that a trader in securities or commodities can make elections to “mark-to-market” their securities and/or commodities and treat increases or decreases in value as ordinary. A fund must be a trader, and not an investor, in order to be able to make a Section 475(f) election. Whether to make a Section 475(f) election is more complicated after the 2017 tax act. Net operating losses cannot be carried back and may only offset up to 80% of income when carried forward. The 2017 act also enacted limitations on excess business losses which may be applicable.
A Section 475(f) election might be beneficial for a fund experiencing losses in 2018 or possibly where a fund has significant net unrealized losses coming into 2018.
A section 475(f) election might also be beneficial where a fund has significant unrealized net gains coming into 2018.
For 2018, for partnerships, the election must be made by March 15, 2018, for existing calendar year taxpayers. For new taxpayers, the deadline is 2 months and 15 days after the start of their year – i.e., March 15, 2018, for taxable years that started on January 1, 2018.
For losses in 2018 and possibly for net unrealized losses as of December 31, 2017, such losses could be converted into ordinary losses and taken in 2018.
Tax benefits of a Section 475(f) election also include avoiding the wash sale rules and the straddle rules.
For gains in 2018 and possibly for net unrealized gains as of December 31, 2017, such gains might, although it is not clear, be converted to ordinary (which would generally be disadvantageous) but the net income as of December 31, 2017, would be included in income evenly over 4 years (that is, 25% each year for 2018 through 2021 regardless of when the income is actually realized). Even if the character of such income is changed to ordinary and even if some of such income could have been long-term capital gains, it might be beneficial to defer 75% of the income and thus the taxes on such income. There would be a risk that tax rates could rise, however.
Conversely, a partnership that already has a Section 475(f) in effect can revoke its election as of January 1, 2018, by revoking its election by March 15, 2018. Any appreciation (and depreciation) after December 31, 2017, would be changed to capital gains but the holding period might include the period the securities were held by the partnership while the partnership was subject to a Section 475(f) election.
In prior years, there were indications that the IRS might issue guidance on Section 475(f) elections that might make them prospective only (i.e., no looking back to the beginning of the year for a timely made Section 475(f) election) and might address character issues as well. However, no such guidance has been issued to date.
Section 475 has many nuances and a Section 475(f) election should be made or revoked only after careful consideration and consultation with your tax advisors regarding the impact on your fund.