Booyah Breakdown: Taxes for Traders II

What is mark to market? It's an option that allows you to treat your securities as if they were sold for their fair market value on the last business day of the year.

But this is only a paper transaction -- you don't actually have to sell everything. You simply subtract your original basis in the security from the fair market value on that last business day of the year and report the result as your gain or loss. (If you're dying for more details, check out Section 475(f) of the tax code.)

This mark-to-market election is a great tax shelter for investors who meet the requirements. However, as with everything in life, there are pros and cons.

On the plus side, you avoid the $3,000 loss limitation. And you don't have to worry about violating the wash-sale rule, which says you can't take a loss on a stock if you bought it within 30 days before or after you sold it.

For example, if you buy a security on Dec. 30 and it falls in value, you can take the loss on Dec. 31 if you mark to market. Because it's only a paper transaction, the wash-sale rule doesn't apply.

On the down side, none of your gains will qualify for the lower long-term capital-gains tax rate of 15%. Instead, they are taxed as business receipts at the higher ordinary tax rate. Keep in mind that if you had paper gains, you'll have to recognize those as well.