Mark-to-Market Election – Whether to Make or Revoke a Section 475(f) Election on or Before March 16, 2020
March 2, 2020 | Hedge Funds
Each year, we send an annual newsletter to our clients and friends on Section 475(f) mark-to-market elections. A 475(f) election must be made by partnerships early in the year (by March 16, 2020 for 2020) and can be overlooked while people are focused on preparing tax returns for the prior year. In a year like 2020, where the market is down at the beginning of the year and some might be sitting on losses, 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 may be more usable for tax purposes 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 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 has become 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. Further, the TCJA 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 2020 or possibly where a fund has significant net unrealized losses coming into 2020.
A section 475(f) election might, however, also be beneficial where a fund has significant unrealized net gains coming into 2020.
For 2020, for partnerships, the election must be made by March 16, 2020, 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, 2020, for new taxpayers that started on January 1, 2020).
For losses in 2020 and possibly for net unrealized losses as of December 31, 2019, such losses could be converted into ordinary losses and taken in 2020.
Tax benefits of a Section 475(f) election also include avoiding the wash sale rules and the straddle rules.
For gains in 2020 and possibly for net unrealized gains as of December 31, 2019, such gains might be converted to ordinary (which would generally be disadvantageous) but the net unrealized income as of December 31, 2019, would be included in income evenly over four years (that is, 25% each year for 2020 through 2023, 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, however, be a risk that tax rates could rise during such timeframe.
Conversely, a partnership that already has a Section 475(f) in effect can revoke its election as of January 1, 2020, by revoking its election by March 16, 2020. Any appreciation (and depreciation) after December 31, 2019, 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.
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.