Not everyone looks forward to tax season …
While most people eagerly anticipate tax returns, day traders often stress over how much of their gains they’ll have to fork over to the IRS.
Whether you trade to earn a little money on the side or it’s your main source of income, there are a ton of tax implications that you need to know.
Taxes on day trading can get a little complicated. Are you even classified as a trader? Can you deduct your losses?
Don’t want trouble with Uncle Sam? Can’t say we blame ya. Here are the basics of day trading taxes, because we want you to be on the IRS’s good side.
Naturally, our nitpicky lawyers want us to share this with you first: This communication doesn’t establish a professional relationship for accountancy, tax advice, legal or any other professional service. Any information presented in our communication with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) regarding any issues should not be construed as advice as it pertains to tax matters, legal matters, or any other matters. Always consult the advice of a professional licensed in your state or jurisdiction before making decisions on tax or legal matters.
OK, now that that’s out of the way, let’s get down to it …
Know Your Status
Just because you trade doesn’t necessarily mean you’re a trader in the eyes of the IRS.
But qualifying for Trader Tax Status (TTS) can open you up to a number of tax benefits that you’ll probably want to take advantage of. So, it’s important to understand how you might qualify for this designation and how it can benefit you.
Now, if you’re not a heavy trader, you probably don’t have to worry about your status for now. And even if you don’t qualify, it’s worth knowing this information … it might apply to you when April rolls around next year.
Trader Tax Status (TTS)
Trader Tax Status is a tax classification that could grant you a few decent tax benefits. One of the biggest is that you can deduct more than the standard $3,000 in capital losses.
So how do you know if you qualify? That’s the hard part — there aren’t really any clear guidelines. Even the official IRS website uses vague language like “Your activity must be substantial” and “You must carry on the activity with continuity and regularity.”
Huh? What does that even mean?
They kind of leave it up to you to determine what constitutes “substantial” activity. You’ve gotta be careful, though. You don’t want to push the limits and get into trouble with the IRS.
While the IRS isn’t clear about TTS eligibility requirements, you can still figure out if you qualify.
Trading Activity
First, as mentioned above, your trading activity must be substantial. To be safe, you might qualify your activity as substantial if you spend about 20 to 30 hours per week trading.
That’s about the equivalent of a part-time job.
On top of that, you also need to be constantly making trades. You should be averaging several intraday trades per day for most of the year. Of course, you can take breaks here and there, but there should be a pretty recognizable pattern of trading activity.
Long-Term & Short-Term Positions
Next, let’s look at long-term versus short-term positions.
Holding multiple long-terms positions could jeopardize your trader status. To qualify for TTS, most of your activity should be day trades. Not all of your activity, but most of it. That’s not to say you can’t also be a long-term investor, but you should keep your long-term positions in a separate portfolio.
To qualify for Tax Trader Status, you need to meet these requirements.
“Attack of the Lawyers” strikes again! IRS CIRCULAR 230 NOTICE. Nothing in our communications with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) relating to any federal tax transaction or matter are considered to be “covered opinions” as described in Circular 230.
Whew … that was short and sweet compared to the first one! And, thankfully, the lawyers say that’s the last one. Thanks, lawyers!
OK, let’s keep moving. Time to get down to the nitty-gritty: profits.
Profits
In addition to the above requirements, it also helps if you made a profit in the past year. That includes all the money you made from trading after deductions.
It’s important to keep in mind that the IRS treats people with TTS as a business, and tax laws state that real businesses should generally be profitable for three out of five years.
You might not have a five-year trading history yet, but it definitely won’t hurt if you made a profit.
Are You Employed?
As we said earlier, you have to have “substantial” trading activity to be considered for TTS.
This doesn’t mean you have to be a full-time trader. But if trading is your main source of income, you’ll have a much easier time qualifying for Tax Trader Status.
The TTS requirements can be pretty vague. If you meet all of the criteria listed above, though, you’ll likely qualify for this status. Take a peek for yourself at what the IRS has to say on this topic at its website.
Mark-to-Market Election
On top of TTS, you can make the mark-to-market election, which can give you some additional tax benefits.
To get these benefits, you have to make the mark-to-market election on April 15 of the previous tax year. So, if you’re just learning about this now, it won’t make a bit of difference on your taxes this year.
But with April 15 coming up, making the mark-to-market election this year could potentially grant you some sweet benefits for the next tax season.
Tax Benefits
For most people, capital losses are deductible in amounts up to $3,000. As a mark-to-market trader, though, your losses are considered “ordinary.” Instead of being limited to $3,000, you can deduct all of your losses.
Hopefully, you won’t have a bad enough year for this to matter too much. But it does happen, and the potential tax savings could mitigate your losses.
And you would also be exempt from the wash-sale rule (we’ll get to that later).
Aside from making the mark-to-market election on April 15, you also have to pretend to sell your entire portfolio at market price on the last trading day of the year. Then, once the new year starts, you pretend to buy all of it back at the same price.
Again, if you’re a new or low-volume trader, this stuff might not apply to you. Still, it’s good to be familiar with these topics in case your activity increases over the next year.
For full-time and high-volume day traders: It’s important to know the steps you can take to potentially save some money when tax day rolls around.
Separate Your Long-Term & Short-Term Investments
Before you file your taxes, you need to understand the distinction between long-term and short-term investments.
It’s pretty simple: long-term investments are positions held for more than a year and short-term investments are held for less than a year.
Short-term investments are taxed at the normal income rate while your long-term investments are taxed at a much lower rate.
For example, the regular tax rate for income from $191,651 to $416,700 is 33%. Compare that to a long-term tax rate of 15%.
Separate Your Accounts
To benefit from lower long-term tax rates without sacrificing your Tax Trader Status, you need to separate your long-term and short-term portfolios.
Your records should identify long-term investments as such on the day that you purchase them. Aside from that, the IRS also requires that traders keep long-term and short-term investments in separate brokerage accounts if you’re trading the same issues.
For practical reasons, you should maintain separate accounts. This can make filing your taxes easier and potentially help you get all the tax benefits possible.
Capital Gains & Losses
Here’s a quick rundown, in case you don’t already know: Capital gains refers to the profits you make by buying or selling a security. Capital losses are the opposite.
Short-term capital gains are taxed at the regular income tax rate. And, as mentioned before, losses are deductible — but only up to $3,000 if you don’t make the mark-to-market election.
Now, how about those forms? Let’s do a brief overview:
If you don’t make the mark-to-market election, you need to report your capital gains and losses on Form 8949 and Schedule D.
You also need to report your trading expenses on Schedule C. Since this doesn’t include any revenue and would automatically show a loss, you should leave a statement on the form explaining that your net trading gains are reflected on Schedule D.
If you make the mark-to-market election, you can report all of your capital gains and losses as business property on Part II of IRS Form 4797.
Whew. Moving on …
Terms You Should Know
For the most part, this should be enough to help you prepare for tax day.
But let’s make sure you aren’t confused by the terminology when you’re filing your taxes. Familiarize yourself with a few key terms …
Earned Income
Earned income is any money that you make from your job — part-time or full-time. This includes salary, tips, bonuses, etc., but it does NOT include trading income.
That means you don’t have to pay self-employment taxes. It may sound nice … until you realize that means you aren’t contributing to social security. And that means you may not be eligible for retirement benefits.
Investment Income
Investment income includes interest, dividends, royalties, and annuities — any income from property held for investment before making any deductions.
Capital gains only count as investment income if you decide to include it.
Cost Basis
Your cost basis is the amount you pay for a security plus any commissions.
Your cost basis is the value used to measure gains and losses. If the value of your position is greater than your cost basis by the time you close your position, it’s a capital gain. If it’s lower than your cost basis, it’s a capital loss.
Wash-Sale Rule
You might remember that one of the benefits of making the mark-to-market election is the exemption from the wash-sale rule.
A wash-sale is when you buy or sell a security at a loss and then buy a “substantially identical” security within 30 days before or after the sale.
The wash-sale rule states that you can’t claim a loss on the sale of a security in a wash-sale.
By making the mark-to-market election and being exempt from this rule, you can spend less time bookkeeping and focus your efforts on trading.
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The Bottom Line
Tax day is stressful for nearly everyone. Not only do you want to save as much money as possible, but you don’t want to make any mistakes that can spell trouble with the IRS.
As a day trader, in particular, there a number of factors that you have to consider that most people don’t …
When you sit down to file your taxes, you need to know how to report your trading income, what you can deduct, and how to take advantage of tax benefits.
While this guide contains a lot of the information you need to prepare for tax day, make sure you always consult a tax professional. Everyone is different; don’t hesitate to get guidance for your specific circumstances.
As a trader, you already know that every dollar counts. So you should do everything you can to prepare for tax day. Do it right!
Are you ready for tax season? Are you starting any key strategies for the new trading year? Share your comments below!
