Investors and traders alike have had a taxing two years. (You didn't think we could resist that one, did you?) But traders have some distinct tax advantages in terms of managing expenses and maximizing losses -- both of which have become increasingly important since the heady days of daytrading peaked. The Internal Revenue Service distinguishes traders from investors pretty much the same way we all do: Investors buy and sell securities for long-term capital gains, as well as to garner dividends, while traders buy and sell securities in an effort to profit from daily price swings. The IRS doesn't have a definitive definition of "trader," nor has it issued rulings for determining trader status. Because traders are considered to be in business, expenses incurred in operating your business -- everything from margin interest to computer equipment -- are deductible as ordinary business losses on Schedule C of Form 1040. You can also claim a home-office deduction, provided the space (including your computer) is used exclusively for business. That deduction is claimed on Form 8829. Investors, no matter how seriously they work, aren't afforded the home office deduction, and their deductible expenses are extremely limited. Traders generally report capital gains and losses on Schedule D, just as investors do. (In an effort to distinguish long-term investments from the trading that represents your "business," it's best to keep the former in a separate account.) Since a trader's sales are, by definition, short-term bets, most gains and losses will be short-term gains and losses (defined by the IRS as held for 12 months or less). Short-term gains reported on Schedule D are taxed at your ordinary income rate; however, traders do not owe self-employment tax on those gains. (Self-employment tax, which is calculated on Schedule SE, provides funds for Social Security and Medicare benefits.) That's some good news. There's some bad news, though, for traders having a bad year. When it comes to capital losses, the same rules that govern typical investors also apply to traders. Capital losses that get reported on Schedule D first must be offset against any capital gains reported on Schedule D. If losses outstrip gains, you can use the losses to offset some ordinary income -- but only up to $3,000. Any excess losses can be carried over to future years, but it won't help with this year's tax burden.
Traders do have a way around that conundrum, though. Traders can elect to report all gains and losses using an accounting method called mark-to-market. The mark-to-market election, which is reported on Form 4797, allows traders to classify actual and unrealized capital gains and losses as ordinary income or loss based on their price at the end of the year. "That's a big advantage traders have over investors," says Mark Luscombe, a CPA with CCH. "As a business you're able to take all the losses in the year you incur them, and you don't even have to sell to realize that loss." For example, let's first say that you actually managed to double the $200 you invested in a stock. Under mark-to-market accounting, you'd pay tax on the $200 gain, without needing to sell the stock. If you sell the stock the following year for $300 (down from $400), you report a loss of $100 in the year you sell it. (Profits reported on Form 4794 are also exempt from self-employment tax.) The same holds true for losses. If a $1,000 investment is worth $100 on Dec. 31, traders can claim that $800 loss and use it to offset any gains or other ordinary income. If the investment, a year later, has risen to $200, you'd owe tax on that $100 gain. Clearly, the strategy is particularly useful in down years, as it enables traders to get the full "benefit" of their losses. The IRS, of course, is aware of this, and doesn't allow traders to make or undo mark-to-market accounting capriciously. Traders need to inform the IRS in a statement attached to your tax return from the year before that you intend to use mark-to-market accounting the following year. In other words, you need to alert the IRS by April 15, 2003 that you plan on using mark-to-market accounting in 2004. (The statement should state unequivocally that for the tax year starting Jan. 1, 2004, you are electing to report gains and losses from your trading business under the mark-to-market rules of Section 475(f), according to J.K. Lasser's Your Income Tax.) It's already too late to establish the practice for 2003 -- the April 15 deadline is hard and fast, regardless of how many extensions you file. Likewise, undoing the election is equally difficult. Traders need to file the not-user-friendly Form 3115, "Application for Change in Accounting Method." Traders also must apply to revoke this election in the year of the change. And the IRS doesn't rubber-stamp the application, either. In fact, if you're still trading on your 1040 and expensing your costs on Schedule C, the IRS is not likely to approve the change. If the events of the past two years have made you think differently about trading, though, you can simply shutter your business. As long as your "investor" accounts have been kept separate, you can simply walk away from the business of trading.