Booyah Breakdown: Taxing Questions

Tax expert Tracy tackles readers' queries to prepare them for that April 15 deadline.
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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 13.

The Booyah Breakdown has been getting a ton of mail these last few weeks, thanks to the recent

taxes for traders articles and

Subprime 101 piece. So today we're going to address some of your questions and comments.

More Trader Tax Issues

Do you know if traders can set up SEP IRAs for themselves? I've heard conflictinginfo on this.

You need earned income to contribute to an IRA. But in most circumstances, a trader generally doesn't have earned income. In addition, even a trader who elects to mark to market does not pay self-employment tax. So a trader generally cannot contribute to a retirement plan.

The only way you could contribute is if your spouse had earned income or if you were receiving alimony.

Another option is to set up your trading business as an S-corporation. That's the most common type of structure for a closely held business, one in which just a few people -- such as family members -- are involved, and there is no intent to have shares available to the public.

S-corporations are taxed like partnerships for federal tax purposes, which means the corporation's income and deductions flow through to the shareholders (or you) and are reported on personal tax returns.

So you could set your trading business up as an S-corp. and then pay yourself a salary. That would give you the earned income you need to contribute to a retirement plan. Then your new business could then set up a SEP-IRA or other retirement plan. And you could, in turn, set up a personal IRA.

But know that you would then owe Social Security and Medicare taxes on your salary. However, it may be worth it to fund your retirement.

Could you please clarify the deductibility of interest paid on margin borrowings through your broker account? When is the interest expense deductible? Do you need to itemize deductions to take advantage of it? Does it offset other income, or can it be used to increase the cost basis of the stock purchased?

Margin interest is the interest your broker charges you when you borrow against your brokerage account.

But you can't add margin interest to the cost basis of the stock. Generally, it's treated as an investment expense. (Read Section 163 of the tax code if you want more grist.) But if you

qualify as a trader in the eyes of the IRS, you can report your margin interest as a business expense on Schedule C.

For an investor, however, margin interest is an itemized deduction and generally is limited to the amount of investment income you have. Form 4952 -- Investment Interest Expense Deduction -- will help you determine just how much of that interest will be allowed as a deduction in the current year. Any unused interest can be carried forward to later years. (See Section 163(d)(2) of the tax code for more on that.)

If, as an investor, you decide to take the standard deduction in 2006, you cannot take a deduction for that margin interest this year. But a portion of that interest may be carried forward to future years.

Can a trader prepare his tax return with TurboTax or any other tax preparation program?

It depends on the program. If it has an option that allows you to enter the information directly onto the tax forms, you should be OK.

For instance, I talked to the folks at TurboTax, and they said you could file as a trader and elect to mark your trades to market if you enter the information yourself using the forms mode. Just be sure to follow the instructions I detailed in a

recent column.

Still, this stuff is complicated. So you might want to consider getting professional help.

Subprime Has Legs

I got a ton of great comments and questions from readers after my subprime story went up.

To start, a reader asked "who ultimately ends up holding these subprime loans? If the subprime lenders just turn around and securitize the loans, why are they the ones taking huge losses to their balance sheets and not the owners of the mortgage-backed securities/collateralized debt obligations?"

This is a great question, especially since

Fannie Mae

(FNM)

recently told

New Century Financial

(NEWC)

, once the nation's largest independent provider of subprime mortgages, that it would no longer buy its loans made to borrowers with poor credit. Bummer.

But this is a fairly complex issue, so the Booyah Breakdown will tackle this topic next week. Stay tuned.

Many readers also pointed out that the subprime contagion has lots of legs and that other, more obscure areas may get hit.

One reader wrote in to say that "subprime lending is also big in the automobile lending industry. Same borrower profile. Same underwriting excesses. Auto subprime blows up on a predicable schedule." Great point.

And finally, "don't forget about the PMI (private mortgage insurance) market," says another reader. Remember, when you put down less than 20% on the home you're purchasing, you usually have to pay private mortgage insurance to safeguard the bank that is loaning you the money. PMI is usually 0.5% of your loan balance each year, and you usually pay it monthly.

So subprime mortgage default insurers such as

PMI Group

(PMI)

may be feeling some backlash soon.

"Especially at PMI," notes the reader, who says "the massive insider selling is hard to ignore. I did find that Bill Miller, of

Legg Mason

(LM) - Get Report

fame, did sell his entire PMI holding."

So keep these companies on your radar. And keep sharing your thoughts. Your fellow readers, and I, thank you.

Next in the tax series: Reducing Your Mutual Fund's AMT Exposure

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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