Editor's note: As a special feature for March,
offers an ongoing series on everything you need to know about taxes. Today is part six.
OK, pour yourself a drink (a stiff one!) and settle in. We've got some heady tax stuff to talk about today.
Last week we talked about
the differences between investors and traders for tax purposes. In a nutshell, it's basically the difference between hobbyists and professionals. Investors invest to increase wealth, but it's really a sideline to their day jobs. For traders, trading is their day job. It puts bread on the table and pays the rent.
The good news is that Internal Revenue Service then treats trading like a business and offers two great tax breaks:
- Capital gains and losses. Typically, your deductible losses are limited to the amount of your capital gains, plus an additional $3,000 a year. But traders have the option of taking an unlimited amount of losses, which can be used to offset any income.
- Business expenses. Because trading is their business, traders can deduct 100% of their expenses, including the cost of their computers and software, tax advice and instructional materials on investing.
This week's Booyah Breakdown is going to delve into the details of these perks now!
Big note: There are no special forms for traders, no box you check to notify the IRS of your special status. But there are specific things traders must do on their returns to alert Uncle Sam to their status and to claim the tax benefits to which they're entitled. Let's look at some of them in depth.
Capital Gains and Losses
Investors and traders who suffer capital losses report those losses on Schedule D -- Capital Gains and Losses. The deduction for those losses is limited to the amount of your capital gains plus $3,000.
But the Taxpayers' Relief Act of 1997 created a special tax break for traders that allows them to avoid that $3,000 loss limitation by electing to "mark to market" their positions at year-end.
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.
If you trade futures, commodities or nonequity options, you can't take advantage of that great 60/40 rule. That rule allows gains to be automatically considered 60% long-term and 40% short-term on Schedule D, regardless of the time the security is held. Instead, everything will be taxed at your ordinary federal tax rate, which could be as high as 35%.
Declaring this election takes some serious thought. The IRS requires you make this mark-to-market election at the beginning of the year. So to be able to mark your trades to market in 2007, you need to include a note on your 2006 return and file it by April 17, 2007.
That also means that if you did not make the election on your 2006 return, you can not mark your trades to market this April.
Finally, once you decide to mark-to-market your positions, for all practical purposes there's no turning back. You can't switch back to reporting only your gains and losses when realized next year without getting the IRS' permission. And, no surprise, that's pretty difficult to get. So be sure it's the right thing to do before you take the plunge.
How to Report Gains and Losses
Line B of Schedule C -- Profit or Loss From Business asks for your business code. There isn't a code for traders, so just choose the code for "other financial investment activities," which is 523900.
Neither is there a box to check that you are electing to mark to market your securities positions. You will have to indicate that election in the way you fill out your Schedules C and D. First, report all your transactions on Schedule D. That way your gross proceeds from sales tie into the Forms 1099-B that you'll get in the mail from your broker come tax time.
Then work through the form until you get to line 16 (total net gain or loss). At this point, you want to make the balance on Schedule D zero so you can transfer it to line 1 (gross receipts) on Schedule C.
How? If you have, let's say, a gain of $10,000, then under line 16, show that amount as a negative number so your Schedule D balance is now zero. (If you have a loss, show the amount under line 15 as a positive number.) Then write "Section 475(f) election to Schedule C" next to the negative amount.
From here, report your gain or loss on line 1 of Schedule C and write "Section 475(f) election from Schedule D" on the line before the amount.
Normally, you must pay self-employment tax on all income on Schedule C. But in this case, you don't. It's an additional perk of having trader status. (See Section 1402(a)(3) for more details.)
On the other hand, you don't qualify for a Keogh, a retirement plan that covers self-employed people, and you don't pay into the Social Security system, so you're on your own for retirement.
Whether you elect mark to market or not, there is another big bonus to trader status. Your trading-related expenses are considered ordinary business expenses and are 100% deductible on Schedule C. In fact, you can take the standard deduction and still deduct all your trading expenses on Schedule C. Pretty cool.
Ordinary investors can deduct expenses (with all their other miscellaneous itemized deductions) only in excess of 2% of their adjusted gross incomes.
There are also other perks to reporting expenses on Schedule C:
- You can take a deduction of up to $108,000 for the full price of any new Section 179 property you purchased that same tax year. Any computer, business machine, fax or phone used in your business can also qualify. This is not available to investors.
- Any investment interest expense related to your trading business is 100% deductible as a normal business expense on Schedule C. For investors, this expense is deductible to the extent of investment income and is reported on Schedule A -- itemized deductions.
- You can take a home office deduction for your trading activity. An investor cannot. In fact, traders should take the deduction as a way of proving their trader status. That means filing Form 8829 -- expenses for business use of your home.
Here's a list of some more deductible trading expenses:
- Accounting fees
- Books, tapes and video courses on investing
- Calculators or adding machines
- Costs of collecting interest and dividends
- Tax advice
- Home computers and software
- Data-retrieval services
- Interest expenses
- Legal fees
- Home office deductions
It's important to make sure you don't try to deduct nontrader expenses. If, for instance, you use
for your trading and investing accounts, the cost of the subscription should be allocated between the two. The IRS will take notice if it feels the allocations are off. So keep a record of the amount of time you spend on each account.
What About Investors?
If you do not qualify for trader status, you are an investor. That means expenses related to your investing activities will be considered "investment expenses." They will go on Schedule A as miscellaneous deductions.
Your gains and losses will go on Schedule D, and you'll be subject to the capital-gains tax rates. On the plus side, any excess losses can be carried forward to future years idnefinitely.
Can You Be a Trader and Investor?
You can be both trader and investor -- trading for a living and having investment accounts on the side. If so, it is imperative that you keep the accounts separate. The mark-to-market election will apply only to trades associated with your trading business.
An easy way to keep your accounts independent is to set up separate email accounts. When you buy a security for your investment account, send yourself an email. That way it's time-stamped. Identify in the email that the security will be held for investment purposes under section 475(f).
By doing this, you will have noted that it's part of your investment portfolio, not as part of your trading business. Now you've got objective evidence that you will be excluding the shares from the mark-to-market election at year-end. Keep in mind that you must do this before the close of the day of purchase.
Whew! Nothing like a little light weekend reading.
If you're a total glutton for punishment, check out the IRS Publication 550 -- Investment Income and Expenses and
Now get back to work and trade!
Next in the tax series: A Reason to Procrastinate.
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;
to send her an email.