Thinking about becoming a day trader? More power to you. If the stock market’s performance over the past few years hasn’t scared you away from the idea, then you just might have the nerve that job requires.
Essentially, achieving trader status confers many more tax benefits than simple active investorhood. Of course, it also comes with the inherent financial risks of being a trader. In this column, I’ll go into more detail on what it takes to meet the tax-law definition of a “trader” and what happens if you do.
Also see: Smart tax strategies for active day traders
Nailing down your tax status
The IRS doesn’t consider you a trader just because you like the way it sounds. But the government also hasn’t gotten around to defining the term. All we have to go by are court cases decided before anyone imagined that people would be clicking the “trade now” buttons on their computers while waiting for the microwave oven to count down. Nevertheless, I’m going to step way out on a limb and tell you how I think you should make the call on your status. Please take the following quiz.
Part I
1. Do you spend lots of time researching and executing your trades?
Just to pick a figure, I’d say you need at least 16 hours a week to be a trader. Of course, more is better.
2. Can you demonstrate a regular and continuous pattern of averaging several “round trips” (a buy and the related sale) for every day the market is open?
Vacations are allowed. But you can’t have weeks or months without much going on unless you have a good reason like the market is dropping and you have no borrowing capacity to sell stocks short. Having at least 1,000 trades a year is good. Less could be problematic.
3. Are you strictly playing short-term positions?
Getting in and out of all your positions on the same day proves you intend only to profit from short-term market swings, as befits trader status. While every round trip doesn’t have to be a day trade, most should be, and holding some stocks for as long as a month or two flushes your claim to be a trader unless these are very isolated instances. You can, however, keep longer-term holdings in a separate investment portfolio without jeopardizing your trader status. More on that later.
4. Can you answer yes to all the preceding questions for an unbroken string of at least six months?
Of course, all year is best. If the six months are the last six months of the year, you are probably OK. Starting and stopping after six full months but before year-end may allow you to claim you entered the business of trading and then abandoned it. But this is pushing the envelope.
Unless you answered yes to everything in Part I, you’ve already flunked. You are an investor in my book. Sorry. If, however, you’ve made it this far, then yes answers to the remaining questions are preferred but not mandatory. If some of your earlier yes answers were a bit shaky, resounding affirmatives will bolster your case for claiming trader status. On the other hand, two or three no answers weaken your position, even if you have nothing but solid yes responses in Part I.
PART II
1. Did you actually make money after all your deductible expenses (investment publications, ISP charges, computer, software, seminars, etc.)?
While traders are allowed to have bad years (just like baseball players), the tax law says a real business generally must be profitable at least three years out of five. You probably don’t have that much history yet, but making a net profit (however small) always helps.
2. Can you say you have no regular full-time job or profession?
I believe you can be a part-time trader, but the IRS is skeptical.
3. If you are claiming trader status for last year, will you be able to do so for this year as well?
Remember you are supposed to be in the continuous business of trading stocks. A multiyear commitment looks more like a business, while a one-year (or shorter) commitment looks more like an aborted investment strategy or a hobby. Granted, a restaurant can rise and fall in the same year, and so can your business of being a trader. It just doesn’t look as good. Having said all that, this question is probably the least important one in this quiz.
OK. That concludes the test, which is nothing more than my humble interpretation of some old court cases along with what I think are appropriate adjustments for the internet era. Just to make sure I’m not leading you astray, I asked a noted guru on the subject of trader tax rules to check my work. He gave me a passing grade.
Based on the quiz results, let’s assume you qualify as a trader. The IRS now considers you to be in the business of buying and selling stocks for a profit. You are therefore entitled to fully deduct your trader-related expenses on Schedule C. However, unlike most sole proprietors (me, for example), you don’t have to pay the dreaded self-employment tax on your net profit. That’s wonderful, but it gets better.
Save more taxes with mark-to-market election
As a trader, you can also make the special “mark-to-market” election. If you do, two very important tax benefits come your way.
* First, you don’t have to worry about the wash-sale rule, which defers the tax loss when you buy the same stock within 30 days before or after a loss sale. If you make lots of trades, this can happen all the time. The disallowed wash sale loss gets added to the basis of the shares that caused the problem. In other words, with the mark-to-market election you won’t have to spend as much time on bookkeeping as you do researching and trading stocks.
* You are also exempt from the $3,000 annual limit on deducting net capital losses ($1,500 if you use married filing separate status). That’s because as a mark-to-market trader, all your trading gains and losses are considered “ordinary,” just like garden-variety business income and expenses. If you have a biblically awful year, you can deduct your trading losses when you would otherwise be limited to a mere $3,000 (or $1,500) write-off. The tax savings should ease your pain.
* Naturally, there’s a price for these goodies. On the last trading day of the year, you as a mark-to-market trader must pretend to sell your entire trading portfolio (if any) at market and book all the resulting gains and losses on your return. You then pretend to buy everything back at the same price. So your stocks start off the new year with basis equal to market value and no unrealized gains or losses.
Also, you can’t take advantage of the 15% or 20% long-term capital-gains rate for stocks in your trading portfolio. However, this really isn’t a problem because you shouldn’t have anything but short-timers in your trading stable anyway. (See below regarding segregating your long-term investments.)
Unfortunately, many traders already missed the chance to make the mark-to-market election for 2018. And you’ll miss out for 2019 as well if you’re not careful. Here’s why. According to IRS Revenue Procedure 99-17, you must have made the election for the 2018 tax year by attaching an election statement to your 2017 return filed by 4/16/18 or to an extension request (Form 4868) for your 2017 return filed by that date. To make the election for the 2019 tax year, you must attach an election statement to your 2018 return filed by 4/15/19 or to a request to extend the filing deadline for your 2018 return (Form 4868) filed by that date.
The bottom line: Many traders won’t be able to take advantage of the mark-to-market rules until the 2020 tax year. If you fit into this category, write a note to yourself to attach an election statement for the 2020 tax year to your 2019 return filed by 4/15/20 or to a request to extend your 2019 return (Form 4868) filed by that date.
One more thing: If you are not a trader during the year before the mark-to-market election takes effect, you have made an “accounting-method change.” This requires filling out Form 3115 (a complicated sucker previously known only to seasoned tax pros). For example, say you qualify as a trader in 2020 and make the mark-to-market election for your 2020 tax year (don’t forget the 4/15/19 deadline). You’ll have to deal with Form 3115 when you prepare your 2019 return sometime in next year. You may want professional assistance with that.
How traders should handle stock gains and losses
If you are a trader who has not made the mark-to-market election, your capital gains and losses from trading go on Form 8949 and Schedule D, the same as gains and losses from investing. Your trading expenses go on Schedule C, which means you’ll automatically show a loss on that form, because it does not include any revenue from your trading efforts. Of course, this makes the IRS nervous, so you should attach a statement to Schedule C explaining that the positive side of your trading business shows up on Schedule D. The statement should also quantify your net trading gain. At least we hope there’s a gain. We also hope it’s more than enough to offset your expenses.
If you are using mark-to-market accounting, you should report all your trading gains and losses on Part II of IRS Form 4797 (Sales of Business Property). Then attach a statement to Schedule C, as explained in the preceding paragraph.
Why you should segregate your long-term investments
I’ve mentioned that you can be both a trader and an investor. So gains from your long-term investments will still qualify for that nice 15% or 20% federal tax rate without diminishing your trader tax benefits.
However, to occupy this “best-of-both-worlds” scenario, your records must clearly identify investment holdings as such on the day you buy them. Also, the IRS says you must keep investment and trading stocks in separate brokerage accounts if you are investing in and trading the same issues. (In any case, it’s a good idea to use separate accounts, so just do that.)
This story was updated on Feb. 8, 2019.
More tips from The Tax Guy
