Mark-to-Market Accounting: Fair Value, Section 475(f), and 1256 Rules

Mark-to-market accounting records assets and liabilities at their current market price rather than the price originally paid for them. Where historical cost accounting freezes a value at the purchase date, this method updates the carrying value at each reporting date to reflect what the asset would sell for today. It governs how banks report their bond portfolios, how derivatives are valued on financial statements, and how active securities traders can elect to be taxed.

Which Assets Get Revalued

Not everything on a balance sheet gets remeasured. Treatment depends on how the asset is classified when acquired, and classification turns on what the holder intends to do with it.

Under the standards originally set in FASB Statement No. 115 (now codified in ASC 320), debt securities fall into three categories:

Trading securities, bought to sell in the near term, are marked to market with gains and losses flowing through the income statement.
Available-for-sale securities are also reported at fair value, but unrealized gains and losses bypass the income statement and land in a separate equity line called other comprehensive income.
Held-to-maturity securities, where the holder has both the intent and the ability to hold until maturity, stay on the books at amortized cost. Day-to-day price swings never touch the financial statements.

The held-to-maturity classification requires genuine commitment. A company cannot park bonds there to avoid reporting losses and then sell them when convenient. If an institution starts selling out of its held-to-maturity portfolio, regulators and auditors will question whether the remaining securities truly belong in that category.¹

Beyond debt securities, derivatives such as futures and options need frequent revaluation because their prices shift rapidly with the underlying asset. Commodities held for trading also get marked to market when reliable quotes exist. The common thread is liquidity: if there is an observable price, the asset is a candidate for this treatment.

How Fair Value Is Determined

Once an asset needs to be revalued, the next question is what price to use. ASC Topic 820 sets up a three-level framework that prioritizes the most reliable inputs and treats management estimates as a last resort.

Level 1 is a quoted price in an active market for an identical asset. Shares of a publicly traded company use the closing exchange price. No judgment involved.
Level 2 is observable data that does not quite meet the Level 1 bar: quoted prices for similar (not identical) assets, or market inputs like interest rates and yield curves used to estimate value. A thinly traded corporate bond might be valued using a comparable bond that trades daily, with adjustments for credit quality.
Level 3 relies on unobservable inputs based on the entity’s own assumptions. When there is no meaningful market activity, the company builds a valuation model using internal data and cash flow projections. This level carries the most subjectivity and demands the most footnote disclosure.

Assets can move between levels as market conditions change. A bond that once traded actively may shift from Level 1 to Level 2 or Level 3 if that market dries up, and those movements have to be disclosed.

Where the Gains and Losses Show Up

At each reporting date, the carrying value of a marked-to-market asset is adjusted up or down to match its current fair value. The trickier question is where the offsetting gain or loss lands.

For trading securities, unrealized gains and losses run straight through the income statement as part of current-period earnings. A $2 million drop in a trading portfolio’s value on the last day of the quarter hits net income that quarter, even though nothing was sold. For available-for-sale securities, the unrealized change goes to other comprehensive income inside the equity section. Trading losses reduce reported earnings immediately; available-for-sale losses reduce equity but leave the income statement untouched until the security is actually sold.

Keeping these records requires tracking both the original cost basis and the accumulated fair value adjustments for every position. That dual tracking is what lets the company calculate the realized gain or loss on eventual sale, and it is why mark-to-market portfolios take more bookkeeping than a buy-and-hold approach.

The Section 475(f) Election for Traders

Mark-to-market is also a tax election. Under Section 475(f), a person engaged in the business of trading securities can elect to use the method for tax purposes.²

To qualify, you have to meet all three IRS criteria: you trade to profit from daily price movements rather than dividends or long-term appreciation, your activity is substantial, and you trade with continuity and regularity.³ Casual investors checking a portfolio once a week do not qualify. The IRS is looking for something closer to a full-time occupation.

What the Election Does

Once active, the election treats every security held at year-end as if it were sold for fair market value on the last business day of the tax year. This deemed sale forces recognition of all gains and losses for the period, whether or not any positions actually closed.²

Trading gains and losses then become ordinary rather than capital. You report them on Part II of Form 4797 instead of Schedule D. The practical impact shows up hardest in losing years. Without the election, individual taxpayers can deduct only $3,000 in net capital losses per year, with the rest carried forward.⁴ With the election, there is no cap on ordinary loss deductions. The wash-sale rules also stop applying to your trading activity.³

One important carve-out: securities held purely for investment can be excluded from the election, but you must identify them in your records on the day you acquire them. The cleanest approach is keeping investment holdings in a separate brokerage account from your trading positions.³ Section 475(f) also allows a separate election for commodities traders, and the two can be made independently.²

Deadlines and Procedures

The filing deadline is strict. You must make the election by the original due date, not including extensions, of the tax return for the year before the election takes effect. To make it effective for 2026, you needed to file by the due date of your 2025 return. If you were not required to file a return for the prior year, the deadline is two months and 15 days after the start of the year the election takes effect, and you place the statement in your books and records by that date.³

The election statement must specify that you are making the election under Section 475(f), identify the first tax year it applies to, and state the trade or business it covers. Attach it to your return or to your extension request. If you are switching from a different accounting method for securities, you also file Form 3115.³

Missing the deadline is a serious problem. The IRS generally does not permit late elections. Relief under Treasury Regulation Section 301.9100-3 exists in theory, but the bar is high: you must show you acted reasonably and in good faith, and that granting relief will not cost the government tax revenue. If you request relief after a bad trading year when the election would produce a large ordinary loss deduction, the IRS treats that as hindsight and will deny relief unless you provide strong proof the timing was coincidental.⁵

Revoking the Election

Once made, the election applies to every future year unless you get IRS consent to revoke it. Revocation requires filing both a notification statement and a Form 3115 to change back to the realization method. The notification is due by the due date of the return for the year before revocation takes effect. If you revoke within five years of making the election, the Form 3115 goes through the IRS’s non-automatic change procedures, which carry a user fee.³

Section 1256 Contracts and the 60/40 Rule

A separate mark-to-market regime applies automatically to certain derivatives, no election required. Section 1256 covers regulated futures contracts, foreign currency contracts, nonequity options, and certain dealer contracts.⁶

As with 475(f), these contracts are treated as sold at fair market value on the last business day of the tax year. The tax character is different. Instead of converting everything to ordinary income, Section 1256 applies a blended treatment: 60 percent of any gain or loss is long-term capital, 40 percent is short-term, regardless of actual holding period.⁶ The 60/40 split is often favorable because long-term rates are lower. Interest rate swaps, currency swaps, credit default swaps, and similar agreements are excluded from Section 1256 treatment.

Why It Matters for Banks

Mark-to-market rules become most consequential where they meet bank capital requirements. Banks must maintain certain capital ratios, and unrealized losses on their securities portfolios cut directly into those buffers.⁷

This dynamic sat at the center of the 2008 crisis. Banks held large portfolios of mortgage-backed securities whose markets effectively froze. With few buyers, observable prices dropped sharply, and fair value rules forced institutions to record those depressed values. Critics argued the accounting created a spiral of write-downs, margin calls, and forced sales; defenders answered that it simply revealed losses that already existed. In April 2009, FASB issued guidance clarifying that fair value in an illiquid market should reflect an orderly transaction rather than a distressed sale.⁸

The opposite problem showed up at Silicon Valley Bank in 2023. SVB had shifted a large share of its assets into held-to-maturity bonds, which are carried at amortized cost. As interest rates climbed through 2022, unrealized losses on that portfolio grew from roughly $1.3 billion at the end of 2021 to about $15.2 billion by the end of 2022, invisible in reported earnings because of the classification. When SVB was forced to sell $21 billion of available-for-sale securities at a $1.8 billion loss to meet liquidity needs, the market saw what the held-to-maturity book was hiding, and the bank failed within 48 hours.⁹ In 2008, critics blamed mark-to-market for forcing recognition of losses. In 2023, keeping bonds at historical cost masked losses until it was too late.

1
Financial Accounting Standards Board (FASB). Summary of Statement No. 115 – Accounting for Certain Investments in Debt and Equity Securities
2
Office of the Law Revision Counsel. 26 USC 475 – Mark to Market Accounting Method for Dealers in Securities
3
Internal Revenue Service. Topic No. 429, Traders in Securities
4
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
5
Internal Revenue Service. Technical Advice Memorandum 200927005
6
Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market
7
Federal Reserve Bank of St. Louis. What Are the Characteristics of Banks with Large Unrealized Losses?
8
Financial Accounting Standards Board (FASB). FSP FAS 157-4 – Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased
9
Office of Inspector General, Board of Governors of the Federal Reserve System. Material Loss Review of Silicon Valley Bank