You can bet thousands of active traders and investors out there are still smarting from the check they wrote to the
on April 16. Maybe you're one of them. And in between the expletives and oaths, you're wishing for a way to ease the pain next year. If so, what you need is a plan, plus some resources on the Web and elsewhere to help implement it. True, we're nearly four months into 2001, but that's still plenty of time.
Learn From the Past
Any plan you devise to minimize the tax consequences of your trading should start off with some cold-hearted self-analysis. Indeed, one positive about the whole tax-preparation ordeal is that it forces you to examine what went on with your investments last year -- with an eye toward improvement this time around. Face it, trading's a business. Without benchmarks and without strategies for avoiding mistakes, you'll lose money just as you would with any other business.
To wit: Analyze the kinds of investment decisions and trades you made last year -- both from a tax point of view and with an aim toward maximizing profits. For example, ask questions like which mutual funds gave you the best returns once tax consequences were factored in. What was your highest percentage winning trade? Did it come from stocks you held for three days or 14 months? Did those results differ significantly once the resulting long- and short-term capital gains taxes were factored in? And given the tax consequences, were the risky trades you made really worth it?
financial calculators can walk you through the process of estimating the tax consequences of each of your trades (both stocks and funds) last year. If you're hung up on what tax rules might apply, check out the links to IRS publications and other information sources contained in this recent
Keep Better Records
Now that you know the source of last year's successes and failures, you can make some needed changes. Sounds boring and commonsensical, but that process starts with keeping better records. If you make just a couple hundred trades per year or less, an easy way might be to keep a ream of three-hole-punched paper in your laser printer. That way, you can print out each emailed trade confirmation when you receive it, and then slap it into a loose-leaf notebook. Never hurts to have a hardcopy back-up.
In addition, you can often download your end-of-day portfolio from your broker's Web site into an Excel spreadsheet -- and save each day as a print-out or a dated electronic file. Exactly how you download this information varies from broker to broker, so give yours a call. An easier alternative might be to download your portfolio into a financial management program like
Quicken ($60) or
Microsoft Money ($55 after rebates). Some brokers have set themselves up to make the download process easier. Check the lists maintained by
Money to see if yours is one of them.
If you're really serious about record-keeping, check out an online service called
GainsKeeper. For prices starting at $49 per year, GainsKeeper will automatically track your portfolio. Sure, a lot of sites do that for free. The difference with GainsKeeper is that it will automatically adjust your account balance to factor in certain hard-to-document events such as stock splits, mergers, spin-offs and wash sales.
(FYI: For an explanation of the wash-sale rule check out this
GainsKeeper's $49 fee allows you to track up to 100 trades per year. Pay $299 per year and you can track up to 5,200 trades. Like Quicken and MS Money, GainsKeeper incorporates tools to simulate the tax consequences of trades you're thinking about. And while Quicken and Money allow you to export data into their respective tax preparation software, GainsKeeper will automatically generate a Schedule D, reporting your aggregate capital gains and losses.
Lest this start sounding too much like a commercial for GainsKeeper, the site does have a couple of limitations you should consider before signing on. Downloading trades from your broker or uploading them from MS Money or Quicken may prove cumbersome. And you might find yourself having to re-enter your daily activity by hand -- not a pleasant task if you're a daytrader who makes 10 to 50 trades per day. Also, GainsKeeper tracks long and short equity positions, mutual funds and DRIPs. But not options.
Options Rules and Regulations
A software program called
OptionMoney ($99-$350. Real Time Data feeds available from the
Chicago Board Options Exchange for $15-$20 extra per month) basically works like Quicken or MS Money. But it incorporates the record-keeping abilities and heinous tax-reporting rules that go along with options trading. You can also use OptionMoney to record equity trades and mutual fund positions. The program lets you first devise an options trading position -- even complicated ones such as a
butterfly spread. Then it automatically tracks your profit and loss while the position is open. At tax time you can automatically export data on the tax consequences of your trades to Quicken's Turbo Tax.
OptionMoney does all the number-crunching in the background, of course. If you want a fairly easy-to-understand primer on the tax rules pertaining to options trading, consult
Taxes & Investing, a 25-page downloadable pamphlet from
Ernst & Young
. Inside you'll find explanations on arcane topics such as how the wash-sale rule may apply to certain options strategies such as a
straddle. There are also some nice charts in the appendix that neatly summarize the possible tax consequences of different equity and options strategies. Again, knowing the tax regs in advance can save you from entering certain options trades if you feel the tax consequences don't justify the risks.
Seek Help, Turn Pro
No matter how good you are at record-keeping, there's a good chance you'll still need a CPA to at least eyeball your return. Most accountants that take walk-in clients probably are not equipped to deal with your 5,000-transaction trade record if you were to dump it on their desks. And paying by the hour for their learning curve could prove expensive. As an alternative, look into larger firms that may have investment tax specialists on board. At least two firms,
DayTraderTax gear their services to serious traders and investors.
Both of these accounting firms' Web sites are worth checking out just for the information they contain. For example, DayTraderTax talks about the possible advantages of placing your trading activities within a corporation. This way your stock trades aren't mixed in with your family's personal tax return. Another possible advantage of incorporating is that it may help you avoid an audit. Daytraders, in particular, can tally up millions of dollars in transactions in the course of a year -- even when their trading accounts only total $50,000 or so -- a fact that might raise a flag with the IRS when your return is processed.
Finally, both accounting firms recommend that full-time traders try to qualify for so-called trader status with the IRS. Trader status is potentially the best way to minimize your trading tax bite next year. (Read a recent
column on the perks and drawbacks of trader status.) For example, while ordinary investors can only deduct trading-related expenses totaling 2% of their adjusted gross incomes, full-time traders may be able to write off
of their costs of doing business. And where ordinary investors are limited in the losses they can deduct, full-time traders should be able to deduct all of their losses against other income.
You've got to show the IRS that you make a living through trading in order to qualify. Hey, it's nice work if you can get it.