Trader Taxes – Complying with Tax Regulations
Note: We strongly recommend that you consult with a Tax Professional familiar with securities and trading law. Pertinent IRS publication references are provided below.
Investor vs. Trader
You must choose to file as an investor or a trader. To file as a trader, you MUST meet strict requirements which are summarized below.
Investors can only deduct $3,000 in capital losses annually with any remaining loss carried forward in future years to offset future income.
Investment expenses are deductible for investors, yet will be lumped with “Other Miscellaneous Deductions” on Schedule A which in total must exceed 2% of your Adjusted Gross Income before applying. Bottom line is that most investors won’t be able to deduct any expenses.
Traders can deduct both capital losses and investment expenses in full.
Investors are subject to the wash sale rule which essentially prevents you from taking losses if you reacquire a similar position within 30 days (essentially an issue at year-end as the IRS doesn’t want you accelerating a “phony” loss in an accelerated year). Alternatively, traders can elect “Mark to Market” status where you would automatically record trade gains and losses based on market value regardless of whether you close the position or not. Mark to Market status must be declared by April 15 of the tax year for which it will first apply.
Keep in mind that electing Trader status increases the chance of an IRS “red flag” on your filing. Bottom line is that you had better be able to support your status.
Futures trading is considered “Section 1256 Contracts” which are automatically taxed 60% Long-Term and 40% Short-Term. This can be a significant issue for those paying high federal and/or state capital gains taxes.
Futures trades are automatically marked to the market.
Self-Employment taxes currently DO NOT apply to investment gains, regardless if you file as an investor or a trader.
The following are key excerpts from IRS Publication 550 “Investment Income and Expenses” addressing securities trading which begins on page 69 and is accessible in full via the IRS publication download site: http://www.irs.gov/forms_pubs/pubs.html. Additional key pages (not recaptured here) include Wash Sales on p.52 and futures trading p.37.
Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.
You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
Your activity must be substantial. You must carry on the activity with continuity and regularity.
The following facts and circumstances should be considered in determining if your activity is a securities trading business.
Typical holding periods for securities bought and sold. The frequency and dollar amount of your trades during the year.
The extent to which you pursue the activity to produce income for a livelihood.
The amount of time you devote to the activity.
If your trading activities are not a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader.”
Note. You may be a trader in some securities and have other securities you hold for investment. The special rules discussed here do not apply to the securities held for investment. You must keep detailed records to distinguish the securities. The securities held for investment must be identified as such in your records on the day you got them (for example, by holding them in a separate brokerage account).
How To Report Transactions from trading activities result in capital gains and losses and must be reported on Schedule D (Form 1040). Losses from these transactions are subject to the limit on capital losses explained earlier in this chapter.
Mark-to-market election made. If you made the mark-to-market election, you should report all gains and losses from trading as ordinary gains and losses in Part II of Form 4797, instead of as capital gains and losses on Schedule D. In that case, securities held at the end of the year in your business as a trader are marked to market by treating them as if they were sold (and reacquired) for fair market value on the last business day of the year. But do not mark to market any securities you held for investment. Report sales from those securities on Schedule D, not Form 4797.
Expenses. Interest expense and other investment expenses that an investor would deduct on Schedule A (Form 1040) are deducted by a trader on Schedule C (Form 1040), Profit or Loss From Business, if the expenses are from the trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss. The limit on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business.
Self-employment tax. Gains and losses from selling securities as part of a trading business are not subject to self-employment tax. This is true whether the election is made or not.
How To Make the Mark-to-Market Election To make the mark-to-market election for 2002, you must file a statement by April 15, 2002. This statement should be attached to either your 2001 individual income tax return or a request for an extension of time to file that return. The statement must include the following information.
That you are making an election under section 475(f) of the Internal Revenue Code.
The first tax year for which the election is effective.
The trade or business for which you are making the election.
If you are not required to file a 2001 income tax return, you make the election by placing the above statement in your books and records no later than March 15, 2002. Attach a copy of the statement to your 2002 return. After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 99-49. Revenue Procedure 99-49 requires you to file Form 3115, Application for Change in Accounting Method. Follow its instructions. Label the Form 3115 as filed under “Section 10A of the APPENDIX of Rev. Proc. 99-49.” Once you make the election, it will apply to 2002 and all later tax years, unless you get permission from IRS to revoke it. The effect of making the election is described under Mark-to-market election made, earlier.
Miscellaneous Reporting Issues
At year-end, your broker will supply both you and the IRS a Form 1099 summary which lists and summaries all transaction proceeds (sales). Make sure your filed total reflects this figure. You are responsible for calculating your cost basis which some brokers also provide to you as a service. (It is my understanding that MB Trading will be doing so beginning for the year 2002.)
If you have substantial trade volume, check with the IRS to see if broker totals would be acceptable and state you have all of the detail available upon request. If you are filing as an investor however, make sure you make wash sale adjustments and I would recommend filing a statement explaining your use of summary figures.
Jarrett Jacobs, CPA
Formerly a Pacific Coast Stock Exchange Floor Specialist and Trader, Wedbush Morgan Securities.
Former Professional Proprietary Trader.