Section 475(f) Mark-to-Market Election
Client Alerts | February 16, 2017 | Hedge Funds
A Section 475(f) election might be beneficial for a fund experiencing losses in 2017 or possibly where a fund has significant net unrealized losses coming into 2017.
Not as well known is that a section 475(f) election might also be beneficial where a fund is experiencing gains or has significant unrealized net gains coming into 2017.
Section 475(f) 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.
For 2017, for partnerships, the election must be made by March 15, 2017, for existing calendar year taxpayers (due to the change in filing due dates for partnership tax returns from April 15th to March 15th for 2016 partnership tax returns). For new taxpayers, the deadline is 2 months and 15 days after the start of their year – i.e., March 15, 2017, for taxable years that started on January 1, 2017.
For losses in 2017 and possibly for net unrealized losses as of December 31, 2016, such losses could be converted into ordinary losses and taken 100% in 2017. An ordinary loss could offset ordinary income and, to the extent not utilized, the ordinary loss would constitute a net operating loss which could be carried back up to two years and carried forward up to 20 years. In addition to ordinary characterization for losses, other tax benefits of a Section 475(f) election include avoiding the wash sale rules and the straddle rules.
For gains in 2017 and possibly for net unrealized gains as of December 31, 2016, 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, 2016, would be included in income evenly over 4 years (that is, 25% each year for 2017 through 2020 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, particularly if tax rates for years after 2017 are significantly reduced by the new Administration. Although it is probably not likely, we might know more about whether tax rates will be reduced, how much tax rates will be reduced and when such lower tax rates would become effective by the March 15th Section 475 filing date.
Conversely, a partnership that already has a Section 475(f) election in effect can revoke its election as of January 1, 2017, by revoking its election by March 15, 2017. Any appreciation (and depreciation) after December 31, 2016, 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 2015 and 2016, 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.
With the stock market hitting record highs, each partnership’s situation may be different and fund managers may have various views on the future of the market and the prospects and timing of lower tax rates and tax legislation. 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.