Identifying Investment Holdings

An important preliminary step when making the mark-to-market election.

Before you make the mark-to-market election, you need to think about identifying any stocks you hold as an investment. Failure to do so could be costly.

What’s at Stake

Suppose you’re a trader and you make the mark-to-market election. In addition to stocks you trade, you have some stocks you hold as investments. You’ve held some of these stocks for years, and they’ve gone up in value a great deal. If these stocks are considered  part of your trading business, you’ll report ordinary income, not capital gain, when you sell them. Even if you don’t sell them, the gain will be treated as ordinary income when you mark to market on December 31. Depending on how much gain you have in your investment stocks, this could be a real disaster.

What You Can Do

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The rules permit you to maintain investments that are not part of your trading business. To do this, though, you have to identify those investments. In other words, you have to make it clear, up front, which stocks are part of your trading business and which are not. You can’t decide later to treat the losers as trading stocks (for ordinary losses) and the winners as investment stocks (to avoid marking to market and get capital gain treatment).

Early in 1999, the Treasury Department issued proposed regulations addressing the identification issue. Final regulations have not been issued, so we haven’t seen the last word on this topic. Here is what the proposed regulations tell us:

  • If you make the mark-to-market election, you must identify any securities held other than in connection with your trading business.
  • Your identification isn’t effective unless you can demonstrate by clear and convincing evidence that the securities have no connection to your trading business.
  • If you hold an investment security and also trade the same security, or substantially similar securities, your identification isn’t effective unless you hold the investment securities in a separate, non-trading account maintained with a third party.

The Treasury asked for commentary on whether these proposed rules are too strict, so it’s possible the final regulations will soften these rules somewhat. Until that happens, you should assume that these strict rules will apply.

When to Identify

The proposed regulations provide that if you want to identify securities as not being part of your trading business, you must do so on the same day you acquire the security (or enter into or originate your position in the security, in the case of short positions or options). If you hold any investment securities at the time the mark-to-market election becomes effective, presumably you can identify them at that time.

How to Identify

Regulations developed for securities dealers provide two ways to identify securities for purposes of these rules. One is to establish a separate account for investment securities, and the other is to clearly indicate on your own records which securities are not part of your trading business.

These rules also apparently apply to securities traders. There’s some question in my mind, however, whether the procedure of identifying shares on internal records makes sense for an individual trader. It will be difficult to establish factually that the identification occurred at the proper time, rather than being made up later. For this reason, anyone who makes the mark-to-market election and holds some securities for investment should establish separate accounts for trading and investment activities, taking care never to mix the activities of the two accounts.

No Connection to Trading Business

Even if you identify securities as investment securities, the IRS can disregard your identification unless you demonstrate by “clear and convincing evidence” that the security has “no connection” to your trading activity. If the IRS rejects your identification, you’ll be required to mark the securities to market at the end of the year, and report any gain as ordinary income. It isn’t clear to me what is meant by “no connection” to the trading business. In particular, it isn’t clear whether investment securities can be used as collateral for trading margin without being drawn into the mark-to-market regime.

Until we receive further clarification from the Treasury or the IRS, the only sure way to avoid problems is to keep your investment securities in a separate account from your trading securities, and avoid using the investment securities as collateral for margin in the trading account. If it’s important for you to use your investment securities as collateral in connection with your trading activities, you should consider whether the benefits of the mark-to-market election are great enough to justify taking the risk that the IRS will treat those securities as trading securities.

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