Day Trader? What You Need to Know
August 23, 2016
Individuals trading securities have great incentive to classify themselves as traders. By default, buying and selling publicly traded securities is an investment activity, with gains and losses being capital in nature, and related expenses being deducted as itemized deductions.
But what about the downside to investor treatment? Net losses are limited to deducting only $3,000 each year, and the itemized deductions are reduced by 2% of your adjusted gross income and killed off entirely if you are in the alternative minimum tax. Yet net gains are typically all short-term, receiving ordinary income treatment. Furthermore, wash sale rules apply. A wash sale occurs when a security is sold at a loss and the same or substantially identical security is purchased 30 days before or after that trade. The impact of the wash sale is that the loss is not deductible, but instead added to the cost-basis of the related security.
By contrast, a day trader, while still reporting trades like an investor, is able to deduct the trade-related expenses against other income as an ordinary loss. Expenses such as trade analysis software and subscriptions become usable as a deduction.
The day trader can make a mark-to-market election (also known as MTM or 475(f) election) by filing a statement with the IRS by the original due date of the tax return for the year preceding the year it is to take effect. For example, an individual would file this election by April 15, 2017, and the election would then be effective retroactive to January 1, 2017, and continue to be effective until a revocation is filed. Such a revocation follows the same timing rules as the election.
The benefits of the MTM are two-fold:
- Net losses are unlimited. Contrary to capital gain treatment, day trades are all ordinary income or loss, and a net loss for the year is fully deductible.
- The transactions are not subject to the wash sale rules.
A potential downside of this election is that any securities held at year-end are treated as sold at the fair market value on December 31, (for a calendar year taxpayer). Those securities now marked to market have their cost basis adjusted to the deemed sale price.
The comparison chart below outlines the various tax treatments and reporting for the various options.
|Investor||Day Trader – no MTM||Day Trader – MTM|
|Gains and losses||CapitalSubject to wash sale rules||CapitalSubject to wash sale rules||OrdinaryHoldings at year end treated as sold on 12/31|
|Reporting||Reported on schedule DSubject to capital loss limits||Reported on schedule DSubject to capital loss limits||Reported on form 4797No limitation on net loss deduction|
|Expenses||Miscellaneous itemized deductionSubject to 2% phaseout and AMT||Schedule CDeductible against other income without limitation||Schedule CDeductible against other income without limitation|
Who is an investor and who is a trader is not a simple matter of self-classification. The distinction can be tough, and the IRS even tougher, since trader status has significant advantages over investor status. Trading must be substantial, continuous, and regular; done to try to take advantage of the swings in the daily price movements; and whose aim is to profit from those short term changes.
Factors the IRS looks at in evaluating trader position are:
- Time period between transaction opens and closes
- Aggregate dollar amount traded and frequency of trades
- Amount of time devoted to trading
- Reliance on trading to provide income
“Substantial, continuous, and regular” is the area that is most often disputed. There is no bright line test, no benchmarks. Each scenario has to be evaluated, taking all factors into account, in order to reach the right conclusion.