Commodity Traders may be taxed under two different methodologies. One I refer to as the “Default Rule” and the other I refer to as the “Mark-To-Market Election Rule”.
THE DEFAULT RULE
Under Internal Revenue Code (“IRC”) section 1256, Commodity Traders are granted two major tax breaks:
Tax Break #1
60% of commodity gains are taxed at the long-term gains tax rate and 40% of gains are taxed are treated as short-term gains. This is known as the “60/40 Rule”.
Tax Break #2
Commodity trading losses may be carried back three years, to offset prior years commodity trading gains.
In order to meet the definition of a Commodity Trader, for purposes of the above popular tax breaks, an individual must be a member of a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission (a.k.a. “regulated exchange”). The definition of a commodity under IRC section 1256 includes any regulated futures contract, any foreign money contract, any non-equity option, any dealer equity option and any dealer securities futures contract. If you trade on a regulated exchange you are a “Commodities Trader” under IRC section 1256 and can avail yourself of the preferential 60/40 Rule.
When such Commodity Traders file their tax returns for the year they report their commodities gains and losses on Form 6781, which is attached to Form 1040 (Federal Income Tax Return for individuals). The gains and losses reported on Form 6781 are divided into two groups: 60% long-term gains and 40% short-term gains. The next step is to move these two groups of gains/(losses) over to Schedule D and they are taxed consequently (long-term gains/losses are netted against short-term gains/losses). If there is a net long-term gain this is taxed at the current popular capital gains tax rate of 15%.
What I just described is the general rule of taxation of Commodity Traders and most Commodity Traders are taxed under this rule. Any expenses you may have incurred (such as margin interest expense) may only be deducted as an itemized deduction and, consequently limited.
MARK-TO-MARKET ELECTION RULE
There is another tax option obtainable to Commodity Traders, however. If a Commodity Trader meets the definite of a “specialized Trader” they are eligible to make the IRC section 475 Mark-To-Market election. This new optional rule came into effect in 1997 under The Taxpayer Relief Act of 1997, which gave Commodity Traders the ability to make the Internal Revenue Code (“IRC”) section 475 Mark-To-Market election. When you make this election it allows Commodity Traders to do two things:
#1 Treat commodity gains and losses as ordinary income (loss). When you make the IRC section 475 Mark-To-Market election you are eligible to file a Schedule C and list your commodity business expenses. Under this election, commodity business expenses have more value as they are no longer considered itemized deductions but, instead, ordinary business expenses. These expenses can then be used to offset other income you reported, such as wages. When you make the Mark-To-Market election, a Commodity Trader is electing out of the 60/40 Rule and, instead, treats all gains and losses as ordinary. The 60/40 Rule is the default rule that is obtainable to Commodity Traders who have not made the IRC section 475 Mark-To-Market election. Most Commodity Traders do not make the IRC section 475 Mark-To-Market election in order to preserve the popular taxation of commodities (60% long-term gain treatment and 40% short-term gain treatment).
#2 Allow Commodity Traders to take deductions on Schedule C for business expenses associated with your commodity trading business. You can only take deductions on a Schedule C where you have a valid IRC section 475 Mark-To-Market election in place.
In order to be eligible for the IRC section 475 Mark-To-Market election a Commodity Trader must meet the stringent tax definition of a Trader. The “Trader” definition, for purposes of the Mark-To-Market election, requires an individual to seek to profit from short-term changes in the market. This trading activity must be substantial, frequent and continuous. You must be a complete-time trader who is trying to capitalize on the momentary swings in the market each day. If you meet the definition of a “Trader” then you are eligible to make the Mark-To Market election, which must be made by April 15th of the current year if you want the election to be effective for the current year. Example: You make the election by April 15, 2012 for tax year 2012. Once in place the election allows you to treat all gains and losses as ordinary (reported on Form 4797, which is attached to your individual income tax return Form 1040).
Commodity Traders cannot take advantage of the 60/40 Rule and take deductions on Schedule C at the same time. It’s one or the other. The 60/40 Rule is only obtainable to Commodity Traders who DID NOT make the IRC section 475 Mark-To-Market election. The ability to take Schedule C deductions is only obtainable to Commodity Traders DID make the IRC section 475 Mark-To-Market election.