Booyah Breakdown: Taxes for Traders

Don't Have a Long-Term Outlook

A trader shouldn't hold onto securities much beyond 30 days. The reason: A trader buys with the expectation of reselling after a rise in value and thereby takes advantage of short-term swings in market. If you hold securities for long periods, the tax courts most likely will conclude that you're an investor.

Look to the case of Fredrick R. Mayer in 1994. The court concluded that Mayer was an investor because his investment activity was intended to achieve capital appreciation and virtually none involved trading based on daily market price swings. The fact that Mayer had more than 22,000 trades executed in his accounts within a three-year period didn't impress the court, especially because it was determined that he had advisers making trades in those accounts on his behalf.

In the Estate of Yaeger vs. the Commissioner ruling in 1989, the tax court held that the taxpayer was not a trader because most of his sales were of securities held for more than one year. The taxpayer's emphasis on capital growth and profit from resale also indicated long-term investment activity, not short-term trading. And in Purvis vs. Commissioner in 1976, the tax court ruled against the taxpayer, who admitted that some of his shares were held for periods exceeding three years. In attempting to distinguish investing from trading, the court said:

"Securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of securities on the daily market. In a trading account, securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis."

Don't Live Off Your Yields

Is your income mostly from gains and losses? Or do you have a substantial amount of interest and dividends? A full-time trader should generally be living off gains and losses, not interest and dividends.

The courts are stalwart on this. People with thousands of trades have been disqualified because they had too much income from interest, dividends and long-term appreciation. How much income from interest and dividends is too much? Of course, they don't tell you that either. It's on a case-by-case basis.

The IRS does tell you that trading must be your "trade or business." That means your family's next meal must depend on your trading business. Here's a good definition from the Research Institute of America: "A trade or business is a pursuit or occupation carried on for profit, whether or not profit actually results. An isolated transaction isn't a business. Merely investing in corporations, however actively, isn't a business."

You must file Schedule C Profit or Loss from Business to prove that this is your business. (We'll get into those tax-reporting details next week.)

Can You Go Both Ways?

Absolutely. You can be both a trader and an investor. Let's say you qualify as a trader but you have a retirement account. The income and expenses associated with your retirement account would be treated as a regular investor's, but trader activities would be treated as part of business income and expense.

Naturally, it's important to keep the accounts separate and compile adequate documentation in case the IRS comes knocking.

So what are you? Most of us are investors, so don't feel so bad. But if you think you're a trader, then tune in next week to learn about the tax perks to working in that frenetic world.

Coming up next in the tax series: Maximizing Your Deductions

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