8.3 Investor vs. Trader, Mark-to-Market (§475), Digital Assets, Options & Nonbusiness Bad Debts

Why This Topic Matters

The Part 1 outline lists investor versus trader, mark-to-market, virtual currency, options (stock and commodity), and non-business bad debts as separate property topics. Each changes either the character (capital vs. ordinary) or the timing of an individual's gains and losses.

Investor vs. Trader

Courts look at the number of trades, holding periods (usually days, not months), time devoted, and whether trading is the taxpayer's primary source of income. A taxpayer can be a trader for one account and an investor for a segregated investment account.

The §475(f) Mark-to-Market Election

• Deadline: The election must be made by the original due date of the prior year's return (a statement attached to the prior-year return or its extension request). For 2025, the deadline was April 15, 2025. A taxpayer who first qualifies as a trader in 2025 generally cannot elect for 2025 after that date. A new taxpayer (such as a newly formed entity) has 2 months and 15 days into the year.
• Effect: Positions held at year-end are treated as sold at fair market value on the last business day. All gains and losses are ordinary, so a large trading loss can offset wages in full and create a net operating loss.
• Change of accounting method: The electing trader also files Form 3115 for the year of change.

Digital Assets (Virtual Currency)

Under Notice 2014-21, digital assets are property, not currency.

• Taxable dispositions: Selling for dollars, exchanging one digital asset for another, and spending a digital asset on goods or services all trigger capital gain or loss (the difference between fair market value received and basis).
• Ordinary income events: Receiving digital assets as wages or payment for services, from mining or staking (Rev. Rul. 2023-14: income when the taxpayer gains dominion and control), from an airdrop, or following a hard fork in which new units are received (Rev. Rul. 2019-24). The fair market value becomes the taxpayer's basis.
• Not taxable: Buying digital assets with dollars, transferring units between the taxpayer's own wallets, and receiving them as a gift (the donee takes the donor's basis).
• Form 1040 question: Every filer must answer the digital asset question; answer "Yes" for any receipt as a reward or payment, sale, exchange, or other disposition.
• 2025 reporting: Brokers report gross proceeds on the new Form 1099-DA; basis reporting begins for covered assets acquired on or after January 1, 2026. Sales go on Form 8949 boxes G through L, and the taxpayer must supply basis from their own records. Beginning in 2025, basis must be tracked wallet by wallet (Rev. Proc. 2024-28 provided a transition safe harbor to allocate unused basis).
• Wash sales: Under current law, the §1091 wash sale rule applies to stock and securities; digital assets that are not securities are not covered.
• Charitable gifts: A donation of a digital asset held more than one year is deductible at fair market value, but because it is not publicly traded stock, a qualified appraisal is required if the claimed value exceeds $5,000.

Investor Stock Options (Puts and Calls)

Employee stock options (ISOs, NQSOs, ESPPs) follow the compensation rules instead.

Section 1256 Contracts: Futures and Commodity Options

Regulated futures contracts, foreign currency contracts, nonequity options (such as broad-based index options and commodity options traded on an exchange), and dealer equity options are Section 1256 contracts:

• Marked to market at year-end, so unrealized gains and losses are recognized.
• Taxed 60% long-term / 40% short-term, regardless of holding period, on Form 6781.
• An individual may elect to carry back a net Section 1256 loss up to 3 years against prior Section 1256 gains.

Example: A futures trader has a $50,000 net Section 1256 gain on contracts held for three weeks. $30,000 is taxed as long-term capital gain and $20,000 as short-term.

Worthless Securities and Nonbusiness Bad Debts

Worthless securities (IRC §165(g)): A stock or bond that becomes completely worthless is treated as sold for $0 on the last day of the tax year, which can turn a short-term holding into a long-term loss. The refund statute is extended to 7 years for these losses. Losses on qualifying Section 1244 small business stock are ordinary up to $50,000 ($100,000 on a joint return) per year.

Nonbusiness bad debts (IRC §166(d)): A loan that is not connected with the taxpayer's trade or business, such as a loan to a friend or relative, is deductible only if:

1. It is a bona fide debt: a real debtor-creditor relationship, ideally with a written note, a repayment schedule, and interest. Loans to family members that were really gifts are not deductible.
2. The taxpayer has basis in it: cash actually lent. Unpaid wages, rent, or fees a cash-method taxpayer never reported as income produce no deduction.
3. It is totally worthless. There is no deduction for partial worthlessness of a nonbusiness debt.

The loss is always a short-term capital loss, reported on Form 8949 (Part I) with a statement describing the debt, the debtor, the collection efforts, and why it became worthless, subject to the $3,000 annual limit against ordinary income.

Example: In 2023, Mia lent her former coworker $8,000 under a signed note. In 2025 the borrower files bankruptcy with no assets. Mia deducts an $8,000 short-term capital loss for 2025, even though the loan was outstanding for two years.