The question of how traders are taxed is not always an easy one to answer. While you may consider yourself a trader, the IRS may not agree for tax purposes. Whether you are classified as a trader or investor is the important first step in deciding how traders are taxed.
Trader. A trader in securities is engaged in the business of buying and selling securities for your own account. Sounds simple enough, right? Well, there are a couple of fine points that must be met.
- A trader must seek to profit from daily market movements in the prices of securities, and not from dividends, interest or capital appreciation.
- Trading activity must be “substantial”
- A trader must carry on the activity with continuity and regularity.
If you can qualify as a trader, you have “Trader Tax Status” and qualify for special treatment. Capital gains and losses are reported on Form 8949 and Schedule D, while expenses are reported as business expenses on Schedule C. You have the best of both worlds: capital gains are not subject to self-employment tax and you can deduce expenses related to your trading, including investment research, dues, publications, software, subscriptions and home office expense.
Investor. An investor is a taxpayer who buys and sells securities for his or her own account if the activity does not meet the definition of a trader. In other words, if you fail to meet the trader definition test above, you are an investor. As an investor, all gains and losses are reported on Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. Expenses related to your investment activity, such as investment research, dues, publications and subscriptions, are not deductible.
If you do qualify as Trader Status, it unlocks another potential benefit: the mark-to-market election. Under this election, gains and losses from trading are reported as ordinary gains and losses and the net losses are not subject to the $3,000 per year capital loss limitations. Under this mark-to-market election, securities held at the end of the year are valued at their fair market value on the last business day of the year. They are treated as sold on the last day of the year at their fair market value and gain or loss is calculated as the difference between the cost basis and fair market value. The wash sales rules also do not apply to a mark-to-market trader.
This is just a sampling of the complexities of trader taxes. There are ways to use smart entity selection to enhance tax savings for traders, which we will write about in a future post.