Editor's note: Day traders have some unique needs when tax time rolls around. In this series of stories, which runs through Monday, TSC tax reporter Tracy Byrnes, with some help from TSC contributing editor Gary B. Smith, guides traders through the maze. Be sure to read the introduction to the series, and join Byrnes and trader tax expert Ted Tesser for a Yahoo! chat Tuesday at 5 p.m. EST.
The difference between investors and traders, in simple terms, is the difference between hobbyists and professionals.
Investors invest to increase wealth, but it's really a sideline to their day jobs.
For traders, trading
their day job. It puts bread on the table and pays the rent. As such, the
Internal Revenue Service
treats it like a business, offering tax breaks in two key areas:
- Capital gains and losses. Typically, your 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.
The IRS, naturally, sets a very high bar for investors to be considered traders. For more on how to distinguish between the two, see the first installment of our Taxes for Traders series,
Trader or Investor? The IRS Wants to Know.
Once you've met the strict definition of a trader, your next hurdle is putting together a tax return that will meet the IRS' particular requirements. 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
. These losses are 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 trades at year-end.
What is mark to market? It is an option that allows you to recognize the value of your securities as if they were sold for their fair market value on the last business day of the year, says Ted Tesser, trader tax specialist and author of the
Trader's Tax Survival Guide
But this is only a paper transaction -- you don't actually have to sell everything. You simply subtract your original basis in the stock from the fair market value on that last business day of the year and report the result as your gain or loss. (Check out
Section 475 of the tax code for more details).
"This truly is the best tax shelter available for investors who meet the requirements," says Tesser.
Still, there are pros and cons to the mark-to-market election.
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, says Jim Calvin, an investment management tax partner at
Deloitte & Touche
in Boston and the editor-in-chief of the
Journal of Taxation of Investments
On the down side, none of your gains will qualify for the lower long-term capital-gains tax rate of 20%, says Richard Shapiro, a securities tax partner with
Ernst & Young
in New York. Instead, they are taxed as business receipts at the higher ordinary tax rate.
And if you trade futures, commodities or nonequity options, you can't take advantage of that great 60/40 rule, which says gains are 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 39.6%.
Finally, once you decide to mark to market your trades, for all practical purposes, there's no turning back. You can't switch back to reporting your gains and losses on Schedule D next year without getting the IRS' permission. And it is very difficult to get, notes Tesser. 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 5239 (or 9999 for just "other"), suggests Tesser.
Neither is there a box to check showing that you are electing to mark to market your trades. You will have to indicate that election in the way you fill out your Schedules C and D.
First, report all your gains and losses on Schedule D. That way, your gross proceeds from sales tie into the Form 1099s that you'll get in the mail from your broker come tax time, says Tesser.
Then work through the form until you get to line 17 (total net gain) or line 18 (total net 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, say, a gain of $10,000, then under line 17, 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 18 as a positive number.) Then write "Section 475 election to Schedule C" next to the negative amount, says Tesser.
From here, report your gain or loss on line 1 of Schedule C and write "Section 475 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 in the eyes of the IRS. (See
Section 1042(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
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, says Tesser.) Ordinary investors can deduct expenses only in excess of 2% of their adjusted gross incomes.
And there are other perks to reporting expenses on Schedule C:
- You can take a deduction of up to $19,000 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 qualify, notes Tesser. 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 only against investment income and is reported on
Schedule A --
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 deductible trading expenses, courtesy of Tesser:
- Accounting fees
Books, tapes and video courses on investing
Calculators or adding machines
Costs of collecting interest and dividends
Home computers and software
Home office deductions
It's important to make sure you don't try to deduct nontrader expenses, says Calvin. 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. Calvin suggests keeping 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.
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, says Calvin. When you buy a security for your investment account, send yourself an email. "That way it's time-stamped," says Calvin. "Identify in the email that the security will be held for investment purposes under 475(b)." That way you've 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 you must do this before the close of the day of purchase.
I'll be devoting my Saturday Tax Forum to questions about taxes for traders, so if you have any, send them to
email@example.com, and please include your full name.
TSC aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.
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