Mark to market is a measurement method that carries an asset or a liability at its current fair value on the measurement date rather than at historical cost, and recognizes the change in that value in the books for the period, before any sale takes place. MTM is the common abbreviation. In US practice the phrase names two different systems that share a name: fair value measurement in financial reporting, and a set of statutory regimes in the Internal Revenue Code that force a deemed sale at year end for tax purposes.
A client can sit inside one, both, or neither.
Mark to Market in Financial Reporting
On the reporting side the measurement is fair value, the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB Statement No. 157, paragraph 5). That is an exit price rather than the price that would be paid to acquire the asset, and valuation carries the standard-of-value question behind it.
What decides where the unrealized change lands is the classification of the instrument, not the act of marking it.
For debt securities classified as trading, unrealized holding gains and losses are included in earnings. For debt securities classified as available for sale, they are excluded from earnings (FASB Statement No. 115, paragraph 13).
Those excluded amounts do not disappear. Unrealized holding gains and losses on available-for-sale debt securities sit on the list of items of other comprehensive income (FASB Accounting Standards Update 2016-01, paragraph 220-10-45-10A). How that section sits alongside the bottom line is covered in net income.
Equity securities took a different road, and this is where older explanations of the term go stale. The same Update superseded the guidance that classified equity securities with readily determinable fair values as trading or available for sale, and requires equity securities to be measured at fair value with changes in fair value recognized through net income (FASB Accounting Standards Update 2016-01). For an equity security inside that Update’s scope the available-for-sale route is closed, so the mark runs through the income statement. Equity investments accounted for under the equity method or resulting in consolidation of the investee sit outside that scope, and an entity may choose to measure an equity investment without a readily determinable fair value at cost minus impairment, plus or minus changes resulting from observable price changes for the identical or a similar investment of the same issuer (FASB Accounting Standards Update 2016-01).
Mark to Market in the Tax Code
There are three separate tax provisions here, and only the trader regime turns on an election covering the whole trading business.
Section 475: Required for Dealers in Securities
Section 475 is headed mark to market accounting method for dealers in securities, and it applies without an election. Any security that is inventory in the hands of the dealer is included in inventory at its fair market value. Any security that is not inventory and is held at the close of a taxable year is treated as if the dealer had sold it for its fair market value on the last business day of that year, with the gain or loss taken into account for that year (26 U.S.C. 475(a)).
The rule has boundaries, and they turn on paperwork. It does not reach a security held for investment, certain debt acquired in the ordinary course of business and not held for sale, or a hedge of a position the mark does not otherwise cover, and a security is not treated as falling into any of those categories unless it is clearly identified as such in the dealer’s records before the close of the day it was acquired, originated or entered into (26 U.S.C. 475(b)).
Character follows the mark. Gain or loss on a security under that year-end rule is generally treated as ordinary income or loss, and the statute’s own exception removes that treatment for gain or loss allocable to a period during which the security was a hedge of a position the mark does not otherwise cover, was held by a person other than in connection with its activities as a dealer in securities, or was improperly identified (26 U.S.C. 475(d)(3)). The same position held outside section 475 would give a capital result, so the regime changes the character of the income and not only its timing.
A dealer, for this purpose, is someone who, in the ordinary course of a trade or business, regularly purchases securities from or sells securities to customers, or regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers (26 U.S.C. 475(c)(1)).
The Section 475(f) Election for Traders
A trader is in the business of buying and selling securities for their own account, with no customers and usually no inventory. A trader may elect the same treatment, recognizing gain or loss on any security held in connection with that trade or business at the close of the taxable year as if it had been sold for its fair market value on the last business day (26 U.S.C. 475(f)(1)(A)). The election may be made without the consent of the Secretary, and once made it applies to that taxable year and every later one unless it is revoked with consent (26 U.S.C. 475(f)(3)).
Timing is where this one is lost. The election has to be made by the due date, not including extensions, of the return for the year before the year it is meant to take effect, by attaching a statement to that return or to the extension request, and late elections are generally not allowed (IRS, Topic no. 429). A taxpayer whose earlier method was anything other than mark to market then has to change methods by filing Form 3115 (IRS, Topic no. 429), and the mechanics of that filing sit in the accrual to cash adjustment.
Section 1256 Contracts
Section 1256 marks a closed list of contracts rather than securities at large: a regulated futures contract, a foreign currency contract, a nonequity option, a dealer equity option and a dealer securities futures contract (26 U.S.C. 1256(b)(1)).
Each such contract held at the close of the taxable year is treated as sold for its fair market value on the last business day of that year, and the resulting gain or loss is short-term capital to the extent of 40 percent and long-term capital to the extent of 60 percent (26 U.S.C. 1256(a)). That split has nothing to do with how long the contract was actually held.
The reporting lands on its own form. Part I of Form 6781 is headed Section 1256 Contracts Marked to Market, and the form splits the net figure on two consecutive lines, one multiplying it by 40% and the next by 60% (IRS, Form 6781).
The two tax regimes do not stack. Section 1256(a) does not apply to securities to which the section 475 year-end rule applies (26 U.S.C. 475(d)(1)).
The Daily Mark in Futures Is a Settlement Practice
Anyone who trades futures meets the phrase daily, and it means something narrower there. The Code defines a regulated futures contract as one for which the amount required to be deposited and the amount that may be withdrawn depend on a system of marking to market, and which is traded on or subject to the rules of a qualified board or exchange (26 U.S.C. 1256(g)(1)). That daily mark moves cash in and out of a margin account as prices move. It is a settlement mechanic that runs under the rules of the exchange, not a book measurement policy a firm adopts.
What Mark to Market Is Not
An unrealized mark is not a realized gain. Nothing has been sold and no cash has moved, and the statute stops the same economics from being counted twice: proper adjustment is made to the gain or loss subsequently realized for whatever was already taken into account under the year-end mark (26 U.S.C. 475(a)). Section 1256 carries the same adjustment (26 U.S.C. 1256(a)).
Fair value accounting is not a synonym either. Fair value measurement is the wider framework that says how a fair value is arrived at for anything it applies to. Mark to market is one consequence of applying that framework: carrying the item at the measured value period after period. A firm can measure a fair value for a disclosure without ever carrying the asset at it.
The book mark and the tax mark rarely land on the same number in the same year, and that gap becomes a temporary difference in the provision. That work belongs to the income tax standard, Topic 740 (FASB Accounting Standards Update 2015-17, Income Taxes (Topic 740)), and the income tax provision and deferred tax assets hold that ground.
Common Questions
Take the fair market value of the position on the measurement date, subtract the carrying amount or the basis, and recognize the difference. Say a client still holds open regulated futures contracts on the last business day of the year, and they are worth more than their adjusted basis.
Adjusted basis of the open contracts 50,000
Fair market value on the last business day 58,000
Gain recognized on the year-end mark 8,000
Short-term portion, 40 percent 3,200
Long-term portion, 60 percent 4,800The split at the bottom is not an allocation the preparer chooses. It is the statute’s own arithmetic, applied to whatever the mark produced.
Yes, and in two of the three tax regimes above it is the default rather than a choice. Dealers in securities are required to use it, and holders of section 1256 contracts are marked at year end unless the contract is part of a mixed straddle the taxpayer elects out of (26 U.S.C. 1256(d)(1)) or is a hedging transaction the taxpayer clearly identified as one before the close of the day it was entered into (26 U.S.C. 1256(e)). The trader election is the one a taxpayer makes for a whole trading business.
The question usually comes from the argument over fair value during the credit crisis. The SEC staff study mandated by the Emergency Economic Stabilization Act looked at exactly that and recommended that the fair value standard be improved rather than suspended, and that existing fair value and mark-to-market requirements not be suspended (SEC, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting).
If your firm is carrying this kind of year-end work on top of everything else in the close, Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can grade the work first through a trial task.
