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How do losses affect MTM basis and gain recognition?
Phil Hodgen
Attorney, Principal
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How do losses affect MTM basis and gain recognition?
This week’s question comes from reader G (lightly edited):I bought mutual funds in 2015. I plan to make a mark-to-market election. At the end of 2015 they were down. As an example on one there was a loss of $800 (it wasn't sold) and I stated the FMV on Dec 31 as $14,500, down from $15,300 adjusted basis. 2 questions:To answer these questions, I will first need to take a look at how loss recognition works for mark-to-market (MTM) PFICs. Then I will talk about how loss recognition affects the basis of a MTM PFIC.
- At the end of 2016 what do I show as my basis in the fund? $15,300 (its purchase price) or $14,500 (its fair market value at end of 2015)?
- In the future if it increases, and say at the end of 2016 the FMV will be $15,500, what is my gain? Is it $1,000 ($15,500 - $14,500) or $200 ($15,500 - $15,300)?
What is a PFIC?
A passive foreign investment company is a foreign corporation that meets either the income test or the asset test of IRC §1297(a):If 75% or more of its income is passive, or if 50% or more of its assets are passive, it is a PFIC.Foreign mutual funds and other similar investments often end up being PFICs. This is because they are often configured in such a way that they will be foreign corporations under US tax law (even if they are not organized as corporations under foreign law), and because usually all of their income is passive.If it is classified as a foreign corporation under US tax law, and it meets the income test or asset test, it is a PFIC.G is assuming that his mutual funds are PFICs, and he is probably correct.How are PFICs taxed?
There are three ways that PFICs are taxed:- Under the default treatment, distributions and dispositions are taxed under the extremely punitive excess distribution rules: Returns of capital can be swept in as taxable receipts. Taxable receipts are subject to a mix of ordinary and maximum tax rates. And there are daily compounded interest charges on top of that.
- Under the MTM election, annual increases in value are taxed as ordinary gains.
- Under the QEF election, income is passed through to the shareholder as either capital gain or ordinary income.
MTM election generally
The MTM election can only be made for what the Code calls “marketable stock”. There are some specific requirements for what qualifies as marketable stock, but basically it is stock that is traded on an exchange. I will assume that G’s PFICs are marketable stock and qualify for the MTM election.When you make the MTM election, you must pretend to sell the stock at the end of every year for its fair market value and pay tax on any gain that arises in the pretend sale. The gain is taxed as ordinary income.Losses and “unreversed inclusions”
For each MTM PFIC, you must keep a record of a running balance that the Code refers to as “unreversed inclusions”. The unreversed inclusions for any PFIC can never be less than zero.Each time you report a gain from the annual pretend sale of your PFIC under the MTM rules, the unreversed inclusions for that PFIC are increased by the amount of the gain you report.If you claim a loss on that PFIC from the annual pretend sale of your PFIC, you decrease unreversed inclusions for that PFIC by the amount of the loss you claim on your tax return. But because the unreversed inclusions can never be less than zero, you cannot claim losses in excess of the unreversed inclusions available. You also cannot use unreversed inclusions from a different PFIC.To put it a different way, you can deduct losses on the annual pretend sale of your PFIC only up to the total amount of prior gains you reported for that PFIC (decreased by losses you were able to claim for that PFIC).Losses you take on PFICs subject to the MTM rules are ordinary losses. You deduct the MTM losses against ordinary income.Example: Losses in excess of unreversed inclusions
What happens if you do the pretend sale and you have a loss that exceeds your unreversed inclusions? This is best answered with an example.Let’s say that you have a MTM loss of $2,000, but you only have $1,000 in unreversed inclusions. You are only permitted to show a $1,000 loss on your tax return, the amount of your unreversed inclusions. You adjust your basis in the PFIC down by $1,000. You also adjust your unreversed inclusions down by $1,000 so that they are now $0, and there are no further MTM losses you can take.If, in a subsequent year, there is another $500 gain, you would pay tax on that gain and unreversed inclusions would once again increase by $500. A loss in a later year would be deductible up to the $500 unreversed inclusions amount.G’s example
This brings us to G’s example. He describes a situation where he purchases a PFIC for $15,300 in 2015. The value of the PFIC is $14,500 at the end of 2015. This is a decrease of $800.G must pretend he is selling the PFIC at the end of 2015. Under the normal tax rules, the sale of this stock would create a capital loss of $800.Under the MTM rules, you have to first ask “do I have any unreversed inclusions that I can use?”. Only if you have unreversed inclusions can you take the loss.In G’s example, there are no unreversed inclusions, because he has never previously had a MTM gain for this PFIC.G does not get to recognize the loss for 2015.This brings us to G’s first question.Question 1
G’s first question is what his basis in the PFIC is at the end of 2016. Assuming he has made no sales or purchases during calendar year 2016, he will be looking at year end 2015 to determine his basis for year end 2016.As a general principle, gain or loss recognition and basis move together. In other words, if you pay tax on a gain associated with an asset, you would expect that your basis in that asset will be increased by the amount of the gain you report. If you deduct a loss associated with an asset, you would expect that your basis in that asset will be decreased by the amount of the loss you report.Because he could not deduct his loss at the end of 2015, his basis in the PFIC did not decrease.G’s basis in the PFIC at the end of 2016 is still $15,300, his original purchase price.Question 2
G’s gain at the end of 2016 is $15,500 (fair market value) - $15,300 (basis) = $200.Why not recognize the entire $1,000 increase from fair market value at the end of 2015 to fair market value at the end of 2016? Because his basis never adjusted down with the decrease in value that took place in 2015, because the loss was not claimed.G’s basis going into 2017 is his original cost basis of $15,300 plus the 2016 gain recognized of $200, or $15,500.Losses upon sale with no unreversed inclusions
Suppose that on December 31, 2015, instead of doing a pretend sale under the MTM rules, G actually sells his PFIC. He would receive $14,500, its fair market value on the date of the sale.His adjusted basis, or purchase price, is $15,300. He has a loss of $800.Under the unreversed inclusion rules for pretend MTM sales, G would not get to recognize the loss.But for losses that arise from real sales, you get a small break: you can deduct the loss under the rules that would normally apply to such assets in the absence of the PFIC rules if there are no unreversed inclusions. In other words, G would get a capital loss.This is the difference between real and imaginary sales under the MTM rules when you have a loss: unreversed inclusions principles apply for the imaginary annual MTM sales; (mostly) normal tax principles apply for the real sales.G would get to recognize a short term capital loss of $800 for 2015 if he were to sell the PFIC at the end of the year.Losses upon sale with unreversed inclusions available
If you do have unreversed inclusions available when you sell your PFIC stock at a loss, you get to claim some or all of the loss against ordinary income, depending on how much unreversed inclusions you have available.Just for fun, suppose that G has held the MTM fund for a several years and has total unreversed inclusions of $100. He sells it for a loss of $250.G can claim an ordinary loss of $100, the amount of his unreversed inclusions in the PFIC. He can claim a long term capital loss of $150, the amount of loss upon sale in excess of unreversed inclusions.Summary
The MTM rules require a pretend sale of your PFIC at the end of every year. The taxation of MTM funds can essentially be reduced to five bullet points:- MTM gains are taxed at ordinary tax rates.
- MTM losses (up to available unreversed inclusions) are deducted against ordinary income. MTM losses in excess of unreversed inclusions are not deducted.
- Basis adjusts up for gains you pay tax on and down for losses you deduct.
- Gains upon sale of a MTM fund are taxed at ordinary tax rates.
- Losses upon sale of a MTM fund are deducted against ordinary income (up to available unreversed inclusions) and any loss in excess of unreversed inclusions is taxed as a capital loss.