What's a Trader?

Also, taxing options trades, rules for a capital-loss carryover and more.
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Happy holidays from the Tax Forum. We hope you have a happy, healthy 1999.

We've got some taxing options trades this week along with more on the rules for claiming trader status. A capital-loss carryover and a 401(k)-IRA issue join our discussion as well.

And if any tax questions arise during your holiday festivities, send them to

taxforum@thestreet.com. Please remember to include your full name.

But first, for those of you in the 15% tax bracket, I'm sorry! I forgot all about you

last week when reader

Rick Pallavicini

asked about capital-gains rates. I told him that for stocks held at least 12 months and a day, any gains at the time of sale will be taxed at the long-term preferential rate of 20%. Any gains generated from sales of securities held less than a year will be taxed at your ordinary tax rate.

That's true except, as reader

Bob Marinellie

pointed out, if you're in the 15% income tax bracket. Then your long-term capital gains are taxed at only 10%.

Now on to your questions.

Am I a Trader or Not?

In an earlier column, you described one of the criteria for trader status as making 200 or more trades per year. My question is, how does the Internal Revenue Service define a trade? If you buy and then sell the same position, is that considered one trade or are the buy and the sell considered two trades? -- Stuart Smith

Stuart,

The issue of trader status continually comes up. One of these days, the IRS will take the hint and make it a little more straightforward. A checklist would be nice. Until then, we must rely on random court cases and expert opinions.

For this question, I went straight to one of our experts: Ted Tesser, day-trader tax specialist. "A trade is not a trade until it is completed," he says. "Trades, by their nature, have to be short term in duration, which we can't establish until the trade is completed. Therefore, 100 round turns

a buy and a sell is 100 trades, not 200." But he notes that nothing is written on this.

But Stuart, I think you should focus more on the bigger picture. You need to ensure that you can prove yourself a trader, rather than an investor, in a court of law. Here are some things to consider:

Your trading activities must be your "trade or business," according to the

Research Institute of America

. That means you're conducting business with the intent of making a profit.

One of the biggest distinctions between a trader and an investor lies in the time horizon. Do you have a long-term or short-term view of the market? The trader thinks short-term and wants quick money. Another factor: the frequency of trading. The IRS is looking for daily traders, not weekend warriors.

Tax authorities will be very skeptical of an individual with a nontrading day job who actively manages his or her personal portfolio. "The rich doctor who moves an active portfolio is not likely to have the court look favorably on him as a trader," says Richard Shapiro, an

Ernst & Young

securities tax partner.

Check out this previous

Options Forum for some additional details on trader status.

Those Taxing Covered Calls

I just joined the site. I have been watching Cramer on

CNBC

regularly. If I write covered calls to eke out a little extra gain, how do I handle taxes when: -- Joseph Parravano

  • the calls expire worthless;
  • I buy the call back;
  • the underlying long-term stock gets called away (if short-term holding)?

Joseph,

First, check out the IRS'

Publication 550 --

Investment Income and Expenses

. Page 53 has a fabulous chart to help you determine the tax status of each situation. But here's the nitty-gritty:

As the writer of the call, the following things will happen to you:

  • If the call expires worthless, you'd report the premium you received on the call as a short-term capital gain.
  • If you bought the call back, you'd report the difference between the amount you paid to buy the call back and the premium you initially received for the call as short-term capital gain or loss.
  • If the underlying stock is called away, that means the call was exercised. That said, when the call is exercised, you increase the amount realized on the sale of the stock by the premium you receive for the call. Whether the gain is short term or long term is determined by the holding period of the underlying stock, not the option.

Carrying Forward Capital Losses

Judicious tax-loss selling will leave me with a net realized short-term capital loss for 1998, which exceeds the $3,000 deductible limit for the year. I understand the portion of the loss that exceeds $3,000 may be rolled forward into future years to offset net capital gains in those years. But does it keep its short-term loss status, being used first to offset any short-term capital gains, or must capital-loss carry-forwards first be used to offset net long-term capital gains? -- Ray Brunsberg

Ray,

You may deduct capital losses up to the amount of your gains,

plus

an additional $3,000 ($1,500 if you're married and filing separately).

The good news is that any losses above that $3,000 can be carried to future tax years for an unlimited time until the loss is exhausted.

The bad news is that the carry-forward amount retains its short- or long-term status, according to

Section 1212(b)(1)(A) of the tax code. So if you're carrying a short-term loss forward to 1999, that is how it'll stay.

There is a great little worksheet in the instructions to

Schedule D --

Capital Gains and Losses

, page 6, to help you determine the amount of your capital loss that can be carried forward.

But I'm Not Using My 401(k)

I have kind of a complex question regarding IRAs. My wife and I both worked full-time part of the year. I had a 401(k) with my employer that I contributed to. My wife did not elect to open a 401(k) with her employer, although one was available. We both quit our jobs and moved to another state. I am now self-employed. My wife now works as a contract-type employee at another firm. If an employer has a 401(k) available to join but you elect not to participate, can you put $2,000 into an IRA instead? Can I put $2,000 into an IRA even though I had a 401(k) for part of the year? -- Ray Cronemiller

Ray,

Because you had a 401(k) plan for a portion of the year and contributed to it, you cannot get the full $2,000 deduction to your IRA unless your adjusted gross income is below $40,000, says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.

As far as your wife goes, I am assuming she is not part of another pension plan at work and that she doesn't have an account balance in the 401(k) plan. That said, because she chose not to participate in the 401(k) plan, she is not considered an active participant. So she is eligible to make the full $2,000 deductible contribution.

But -- there is always a but -- because you, as her spouse, are an

active

plan member, your wife would only get the full $2,000 IRA deduction as long your

joint

adjusted gross income is above $2,000 but does not exceed $150,000. Above $150,000, the amount of her deduction is phased out as your income reaches $160,000. Check out

Publication 553 --

Highlights of 1997 Tax Changes

for more details.

TSC Tax Forum 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.

As originally published, this story contained an error. Please see

Corrections and Clarifications.