Mark-to-Market Election – Whether to Make or Revoke a Section 475(f) Election on or Before March 15, 2021
Each year, we send an annual newsletter to our clients and friends regarding Section 475(f) mark-to-market elections. A 475(f) election must be made by partnerships early in the year (by March 15, 2021, for 2021) and can be overlooked while people are focused on preparing tax returns for the prior year. A 475(f) election generally offers traders in securities or commodities a way to convert what would otherwise be capital losses into ordinary losses, which are not subject to the same limitations as capital losses and may be used to offset other income.
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 any appreciation or depreciation as ordinary income or loss. A fund must be a trader, and not an investor, in order to be able to make a Section 475(f) election.
For 2021, for partnerships, the election must be made by March 15, 2021, for existing calendar year taxpayers. For new taxpayers, the deadline is two months and 15 days after the start of their year (i.e., March 15, 2021, for new taxpayers that started on January 1, 2021).
Whether to make a Section 475(f) election became more complicated after the Tax Cuts and Jobs Act of 2017 (the “TCJA”). Net operating losses can no longer be carried back and may only offset up to 80% of income when carried forward (subject to changes for years prior to 2021 under the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”)). Further, the TCJA also enacted limitations on excess business losses which may also be applicable (the CARES Act deferred the application of the excess business loss rules to 2021).
A Section 475(f) election might be beneficial for a fund experiencing losses in 2021 or possibly where a fund has significant net unrealized losses coming into 2021.
For losses in 2021 and possibly for net unrealized losses as of December 31, 2020, such losses could be converted into ordinary losses and taken in 2021.
If you make a Section 475(f) election, you will also get the benefit of not being subject to the wash sale and straddle rules.
A Section 475(f) election might also be beneficial where a fund has significant unrealized net gains coming into 2021. For gains in 2021 and possibly for net unrealized gains as of December 31, 2020, such gains might be converted to ordinary (which would generally be disadvantageous) but the net unrealized income as of December 31, 2020, would be included in income evenly over four years (that is, 25% each year for 2021 through 2024, 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. However, an increase in tax rates during such time frame would reduce the benefit.
A partnership can generally make a Section 475 election as of January 1, 2021, and then may be able to revoke the election in 2022 (by March 15, 2022) effective as of January 1, 2022.
Conversely, a partnership that already has a Section 475(f) in effect can revoke its election as of January 1, 2021, by revoking its election by March 15, 2021. Any appreciation (and depreciation) after December 31, 2020, would be treated as capital gain (or loss) 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.
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.