Traders' Exemption From Wash Sale Rules

Article written by EricBank

The U.S. tax rules contain a number of incentives for securities traders and dealers that are not available to investors. By "trader," we mean someone who is engaged in the business of trading securities (and/or commodities), as defined by the IRS:

.   You seek profits from daily market movements in prices

.   Your activity is substantial

.   Your activity is continuous and regular

The IRS applies a set of criteria to evaluate the facts and circumstances surrounding your self-identification as a securities trader, but let's assume for this article that you qualify. One of the perquisites you'll receive is the suspension from wash sale rules, but only if you adopt mark-to-market (MTM) accounting procedures. Let's take a closer look at wash sale and MTM rules to better appreciate the benefits a trader receives.

Wash Sales

Normally, investors must postpone tax-deductions on trading losses if they buy the same security 30 days before or after selling it. This applies to long and short trades:

Example 1: Long Trade

You buy 1,000 shares of ZZ Corp for $10,000 on February 1. On August 13, you sell the shares for $9,500, and normally you would use the $500 loss to offset other capital gains and up to $3,000 of ordinary income. However, you decide to repurchase the 1,000 shares on August 22. That makes the August 1 transaction a wash sale. You must now instead add the disallowed loss of $500 to the cost basis of your August 22 shares, which has the effect of postponing the tax benefit from the loss until you later sell those shares.

Example 2: Short Trade

You borrow and short 500 shares of YY Corp, receiving $5,000 in proceeds that your broker locks up in your margin account. To your horror, the stock starts rising, and you buy it back to cover the short sale one month later, on June 7, for $6,000, a $1,000 loss. The loss will be subject to the wash sale rule if you short the stock again within 30 days of June 7.

Wash sale rules also apply to if you reinvest a mutual fund dividend within 30 days of selling the mutual fund shares for a loss. In addition, wash sales rules apply to repurchases (or re-shorts) made in a retirement account within 30 days of a loss on the same security in a taxable account.

The IRS helpfully points out in the instructions to Form 4797, page 2, that, as a trader of securities, you can avoid the wash sale rules by marking to market.

Marking to Market

You can inform the IRS that you've elected mark-to-market accounting by including a statement with your tax return stating:

1.    You are making the MTM election under IRC 475(f)

2.    The tax year when the election is to become effective

3.    The name of your trading business

MTM accounting calls for you to act as if you sold and repurchased all your holdings at the closing market prices on the last trading day of the year. In effect, you are realizing an ordinary gain or loss on positions that otherwise would have unrealized gains and losses. You'll pay the current-year taxes on the phantom sales and use the MTM prices as the new cost bases for the securities going into the new year.

Traders Accounting will be happy to assist you to set up as a securities trader and handle all your MTM processing.