The Section 481(a) Adjustment

A technical issue in making the mark-to-market election.

There’s an arcane aspect of the mark-to-market election that confuses many people, including knowledgeable tax professionals. The question is what you report as the section 481(a) adjustment when you file Form 3115 for the mark-to-market election. Here’s an explanation of this adjustment.

Purpose of the Adjustment

When you change a method of accounting, it’s possible you’ll have some items that are either duplicated or omitted because they’re treated differently under the two accounting methods. For example, suppose you switched from cash accounting to accrual accounting at the end of 2003. In January 2004 you paid an expense that relates to the previous year. You can’t deduct this amount under the cash method in 2003 because you didn’t pay it that year. Likewise, you can’t deduct it under the accrual method in 2004 because it relates to the previous year. The section 481(a) adjustment correct for this type of problem. In this case, the adjustment would be an added deduction  to make up for the fact that this item fell through the cracks when you changed your method of accounting.

The Mark-to-Market Election

The mark-to-market election requires you to treat the securities in your trading account as if you sold them for fair market value on the last day of the taxable year, with and resulting gain or loss reported as ordinary income or deduction. Under this method of accounting, you’re treated as if you sold your trading securities for fair market value at the end of the year. Your basis for the securities is adjusted for any gain or loss, with the result that for any securities held at the end of the preceding year, basis equals year-end value.

For the last year before the mark-to-market election takes effect, you’re still using the normal tax rules to report gain or loss. You don’t treat your securities as sold on the last day of the year. Yet under the mark-to-market system, which you’re using as of the beginning of the next year, your basis is equal to the value of the securities at the end of the preceding year. That creates the potential for duplication or omission of gain or loss.

Example: At the end of 2004 you held shares with $24,000 basis but value of $26,000. You made the mark-to-market election effective beginning in 2005, and ended up selling these shares for $30,000. You report $4,000 of gain on the sale of the shares, and in addition you have a $2,000 section 481(a) adjustment.

If you’re a true day trader, you don’t hold securities overnight. In that case you won’t hold any securities at the end of the year, and your section 481(a) adjustment will be zero. If you held securities at the end of the year preceding your first year using the mark-to-market method, your adjustment is the difference between the value of those securities at the end of the year and your adjusted basis for the securities.

Tax professionals looking for authority on this point should review Rev. Rul. 93-76. Although this ruling deals with dealers rather than traders, it explains how the section 481(a) adjustment works in connection with a change to mark-to-market accounting.