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Booyah Breakdown: Taxes for Traders

Whether you are a trader or an investor makes a big difference when you file your taxes.

Editor's note: As a special feature for March,

TheStreet.com

offers an ongoing series on everything you need to know about taxes.Today is Part 2.

While Cramer typically says that you shouldn't let taxes influence your trading decisions, he's not excusing you from filing a tax return.

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And while that process can be almost as mind-boggling as Tuesday's market fall, it is a necessary evil. The good news is if you happen to make a living as a trader, you may qualify for some very cool tax perks.

But first you must determine if you really are a trader in the eyes of Uncle Sam. You may feel like one because you're constantly glued to the ticker on your computer, but unless you meet the IRS' stringent guidelines to qualify for "trader status," you're considered an "investor" in their eyes.

So this week's Booyah Breakdown will help you determine just where you stand.

Are You a Trader or an Investor?

It's an important distinction. The IRS considers investing to be a kind of hobby. But trading is a business, eligible for greater tax breaks and a 100% deduction of legitimate business expenses. Plus, a trader has the option of using trading losses to offset an unlimited amount of income.

Daytrading was the cool new thing to do during the tech boom -- but individuals who consider it their profession have been around for years. And until the Taxpayers' Relief Act of 1997, the tax code never acknowledged them.

That has changed, but the IRS still hasn't offered taxpayers any detailed guidance on who is considered a trader. Instead, we have no choice but to look to arcane case law dating back to the 1940s for an answer.

From the case law, experts have fashioned some guidelines. To be considered a trader, you must:

  • Trade for your own personal account. And you must do the trading yourself. You can't hire someone to do it for you, nor can you trade for someone else (although it is possible to be in a partnership which is a trader and run by someone else, according to Ernst & Young). If you have clients or customers, then you're a dealer, and we're not going there today.
  • Attempt to make your living off your trading. It's not just something you do at lunch or in your spare time.
  • Trade to take advantage of market swings. A trader holds securities for a very short period of time, around 30 days, and focuses on short-term gains rather than dividends and long term gains.
  • Trade based on technical, rather than fundamental, factors.

It's important to note that if only one or two of these criteria apply to you, you are not a trader. All must apply, and even then, it's not a sure thing. The devil is in the details, so take a closer look at the requirements.

Weekend Warriors Don't Count

If your trading is a hobby, forget about qualifying. To be considered a trader, your trades must be "frequent, regular and continuous," and you must spend a substantial amount of time doing them. The doctor who does a lot of trades between patients doesn't count. But beyond that, it gets fuzzy. The IRS doesn't define "frequent" or "substantial." So we resort to case law.

In the case of Stephen A. Paoli in 1991, a court rejected the taxpayer's testimony that he spent four hours trading daily throughout the year and found that most transactions occurred in one month. His trading was deemed not to be frequent, regular and continuous, and he was denied trader status. The court also concluded that Paoli didn't depend on income from his trading. He actually received substantial pay from his solely owned corporation.

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

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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