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Trading's Tricky Tax Issues

Advanced investors face tax complexities involving frequent trades, options and short sales.

If you're an active trader, prepare yourself for some thorny tax issues.

Between the constant trades, some option bets and those short sales, your

Schedule D -- Capital Gains and Losses

could end up being more complicated than those open calls.

The one upside to trading a lot is that you may qualify for the beneficial "trader election," which could save you some tax dollars. But like all good things, there's a catch.

So read on to learn more about some of your bigger tax concerns.

What's Up With the Mark?

"At this point, the biggest issue for active traders is whether you should make the traderelection for 2006," says Janice Johnson, the founding chairwoman of the New York State Society of CPA's taxation of financial products committee.

This trader election allows you to mark your trades to market. That means you can recognize the value of your securities as if they were sold for their fair market value on the last business day of the year.

Now don't get nervous -- this is strictly a paper transaction. You don't actually have to sell everything. Just 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 if you want more grist).

The best part of this election is that you can declare an unlimited amount of losses. Remember, a regular investor's losses are limited to the amount of his capital gains plus another $3,000. If you make this trader election, the sky's the limit.

So if you have a bad year, this election can be a huge help. But if you win big, expect to pay big, because none of your gains will qualify for the lower long-term 15% capital gains tax rate. Instead, those gains will be taxed at your ordinary tax rate, which could hit 35%.

One more downside: Once you make the election, you're stuck with it. You can't flip-flop each year. You'll need to petition your decision with the IRS. And remember, you're making this election for the 2006 tax year. If you didn't make this election last year, with your 2004 tax return, then you can't mark your trades to market on your 2005 return.

But let's first determine if you qualify this treatment.

To Trade or Not to Trade

You may be a trader, for tax purposes, if:

  • You trade for your own personal account. And you must do the trading yourself. You can't hiresomeone to do it for you, nor can you trade for someone else. If you have clients or customers,then you're a dealer, and we're not going there today.
  • You make your living off your trading. It's not just something you do at lunch or in yourspare time.
  • You trade to take advantage of market swings. A trader holds securities for a very shortperiod of time, around 30 days.
  • You trade based on technical, rather than fundamental, factors.

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 be really sure about your decision or you'll have Uncle Sam breathing down your back.

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If you think you qualify, then you need to inform the IRS by April 15 that you want to make the election for the 2006 trading year. There's no official form, so create a written statement and attach it to your 2005 tax return or extension.

And one more important point: Be very specific about which accounts you want to mark to market, says Johnson. Leave your long-term investment accounts or any commodities trades outside this election.

Why? To start, you want your long-term accounts to get the beneficial 15% long-term capital gains rate. And on the futures/commodities front, you want their beneficial treatment as well. Typically, futures, commodities and nonequity options are subject to the great

60/40 rule

. The 60/40 rule says those gains are automatically considered 60% long term and 40% short term on Schedule D, regardless of the time the security is held. So don't lose that perk to the mark to market election. Keep those trades in a separate account.

Shorty Shorts

If you dabble in short positions, pay attention.

Only when a short position is closed is there a taxable event. So you report short sales only in the year you cover them. If you are holding an open short position at year-end, you won't owe tax on it.

But if you do have open positions on Dec. 31, the gross proceeds reported on your

Form 1099-B -- Proceeds from Broker and Barter Exchange Transactions

will be greater than the amount you report on your tax return.

You'll need to attach a reconciliation schedule. It can be a plain sheet of paper with your name and Social Security number on it. Write "see attached schedule" in column (a), then attach a form that should look something like this:

Gross proceeds from Broker ....xxxx

Less short sales to be reported next year ....yyyy

Total reported on Schedule D ....zzzz

The final number should be the total sales in column (d) on Schedule D.

Option Options

The sale and purchase of calls and puts are reported just like those of stocks. Everything goes on Schedule D. Just don't forget to subtract commission fees from the sales price and add them to your original cost.

Option trades are not reported on your Form 1099-B (I know, it's nutty). Still, these trades must be reported on your tax return, so you'll need to do a simple reconciliation, otherwise the amount you report on your Schedule D will not match the amount on your 1099s.

If the total sales price you're reporting on your tax return is larger than the amount reported on your

1099-B -- Proceeds from Broker and Barter Exchange Transactions

, you're probably not going to have a problem. If that's the case, you're paying more tax than the Internal Revenue Service belives you should, and I doubt Uncle Sam will argue about that.

But if the amount you report is less than what is on your 1099-B (i.e., you're a really bad options trader), attach a simple schedule explaining the difference. Be sure to put your name and Social Security number on it. Then show the difference as a lump sum. Say you're down $2,000. Just show that $2,000 as a "difference due to option trading losses." There's no need to show every transaction. You'll just confuse the IRS.

Remember, if all you do is trade options, you won't get a Form 1099-B at all. So, again, just attach a quick explanation of your total sales proceeds (i.e., "sales from options trading").

And on a final note: In general, if you keep a detailed trading schedule throughout the year or use a service like, you can just attach that detail. As long as it contains the same info as Schedule D, just transfer the grand totals to Schedule D and write "see attached schedule" in the description column. Just write "various" in the date columns.

So while active trading may give you a rush throughout the year, it's pretty sure to give you a splitting headache come tax time. So pour a cup of coffee, take your time and just deal with the minutiae.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for 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 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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