It's advantageous for short-term investors to qualify as traders, rather than investors, for federal income tax purposes. Unfortunately, there's no bright-line distinction between trader and investor status. Here's an overview of the IRS and U.S. Tax Court guidance to help determine if you qualify as a tax-favored securities trader.
Potential upsides of qualifying for professional trader status for tax purposes include:
Traders can deduct expenses on Schedule C and benefit from SE tax exemption. They're considered to be in the business of buying and selling stocks (and other securities, if applicable) for a profit. Therefore, traders can fully deduct trading-related expenses on Schedule C like any other sole proprietor. However, unlike most sole proprietors, they don't have to pay self-employment (SE) tax on their net profit from trading.
Traders can make the "mark-to-market" election. Traders who make this election enjoy two important tax advantages. First, they don't have to worry about the wash-sale rule, which defers a tax loss when the same stock is bought or sold within 30 days before or after a loss sale. The disallowed wash-sale loss gets added to the basis of the shares that caused the problem. But, with the mark-to-market election, a trader doesn't have to spend any time on unproductive bookkeeping to comply with the wash-sale rule, freeing up time for researching and trading stocks.
Second, traders who make this election are 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, gains and losses from trading are considered ordinary gains and losses, like garden-variety business income and expenses. So, if a trader has a bad year, his or her net trading loss can be fully deducted, rather than being limited to $3,000 (or $1,500).
According to the IRS, you must meet the following three conditions to be properly classified as a securities trader for federal income tax purposes.
Consider the following factors to help determine if you engage in the business of trading securities:
If your trading activities don't amount to a business, you're considered an investor. It doesn't matter if you prefer to call yourself a trader or a day trader.
Important: You can be a trader in some securities and hold other securities for investment. The special federal income tax rules apply only to your trading portfolio. So, you should keep detailed records to distinguish securities held for investment from securities bought and sold in your trading business. Securities held for investment must be identified as such in your records on the day you acquire them. The easiest way to meet this requirement is to simply hold all your investment securities in a separate brokerage account.
Traders who make the mark-to-market election must pretend to sell their entire trading portfolio at market prices on the last trading day of the year and include all the resulting tax gains and losses on their personal tax returns. If a trader has an overall gain, his or her tax bill goes up accordingly even though the shares haven't actually been sold. This could create a liquidity issue for cash-strapped traders.
Next, mark-to-market traders must pretend to buy back everything that they pretended to sell at year end at the same price. So, stocks in their trading portfolio will start off the new year with tax basis equal to market value and no unrealized gains or losses. That's the mark-to-market concept in action. However, if a trader empties out his or her trading portfolio at the end of the year, or nearly so, this mark-to-market drill is either not applicable or relatively inconsequential.
A trader can't benefit from the preferential 15% or 20% federal income tax rates on net long-term capital gains for gains from stocks held in his or her trading portfolio. But this really isn't a problem because a trader shouldn't have anything but short-term investments in his or her portfolio.
A taxpayer can be both a securities trader and an investor at the same time. This dual classification allows long-term gains from the taxpayer's nontrading portfolio to qualify for the favorable 15% or 20% federal income tax rate without diminishing the tax benefits available for his or her trading activity.
To qualify for this best-of-both-worlds position, the taxpayer's records must clearly identify nontrading investments as such on the day they're bought. Also, the IRS requires separate brokerage accounts for investment stocks and trading stocks if the trader invests and trades in the same issues. Maintaining separate accounts will also make things cleaner if the trader gets audited by the IRS.
Making the mark-to-market election requires forethought. To make the election for the 2024 tax year, a trader needs to attach an election statement to their 2023 return filed by April 15, 2024, or to an extension request for his or her 2023 return filed by that date.
As a result, many traders won't be able to take advantage of the mark-to-market rules until the 2024 tax year at the earliest. It's also important to note that traders who haven't already made the mark-to-market election will need to apply for an accounting method change on IRS Form 3115 for the year the election is to take effect.
For example, Sam qualified as a trader for 2023 and will again for 2024. She makes the mark-to-market election for her 2024 tax year when she files her 2023 federal income tax return on April 15, 2024. Sam must include Form 3115 with her 2024 tax return when she files it next year.
Despite the inherent financial risks of being a securities trader, this status offers important benefits from a federal income tax perspective. Contact your tax professional to determine whether you qualify. If so, your advisor can help you make a timely mark-to-market election and properly report your trading gains, losses and expenses.
What's the right classification for your trading activity? In the absence of specific IRS definitions of the terms "trader" and "investor," ask yourself these seven questions to help you get it right.
The more time you spend on trading-related activities, the more likely you'll be considered a trader. A good rule of thumb might be that traders spend at least 16 hours a week on such activities.
A so-called "round trip" consists of a buy and the related sale. Traders usually engage in at least 1,000 trades per year. Although traders can take vacations like everybody else, they generally can't go weeks or months without any trading activity. However, exceptions may be allowed if, for example, the market is dropping and you have no borrowing capacity to sell stocks short.
Getting in and out of all your positions on the same day proves you intend to profit only from short-term market swings, as befits professional trader status. While every round trip doesn't have to be a day trade, many should be, and holding some stocks for as long as a month or two diminishes your claim to trader status unless these are isolated instances. You can, however, keep longer-term holdings in an investment portfolio held in a separate brokerage account without jeopardizing your trader status with the IRS, as explained above.
A 2015 Tax Court decision illustrates this point. In Poppe, the taxpayer was found to qualify as a securities trader for the year in question because he: 1) executed about 60 trades per month, 2) devoted four to five hours per day to trading on days when the markets were open, and 3) always traded during the last hour of the day when there's heavier market activity. His trading was largely in stocks and options that were held for less than one month. (William Poppe, TC Memo 2015-205.)
If these six months are the last six months of the year, you're 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, unless you answered "yes" to everything so far, you're probably an investor rather than a trader.
"Yes" answers to the following questions are preferred, but not mandatory. If some of your earlier yes answers were shaky, resounding affirmatives to the remaining questions will bolster your case for claiming trader status with the IRS. On the other hand, two or three "no" answers weaken your position, even if you have nothing but solid yes responses to the earlier questions.
Examples of deductible items include the costs of online investment advice services, computer hardware/software and seminars. While traders are allowed to have bad years, the tax law says a legitimate business activity generally must be profitable at least three years out of five. If you don't have that much history yet, making a net profit (however small) always helps.
People with full-time jobs may not have time to participate actively enough in trading activities to qualify for trader status. A 2014 Tax Court decision highlights this point. In Assaderaghi, the taxpayer worked full-time as a corporate vice president of engineering. He also traded securities on the side. During the two tax years in question, his trades included security purchases and sales, put and call options, and short sales.
In the first year, he executed 535 trades on 154 days. However, over half of those trades occurred in just three months (January, June and July). In the second year, the taxpayer executed 180 trades on 94 days, but he traded on fewer than 10 days each month from January through June. In the first year, the taxpayer had $2,659,696 of gross trading receipts, and he had $349,991 for the following year.
The Tax Court found that taxpayer didn't qualify for trader status — but didn't provide any bright-line thresholds for making this determination. However, it looked at earlier decisions in which the court concluded that making 189, 204, 289, 303, 313 and 372 trades in a year was insufficient to qualify for trader status with IRS, but that making 1,136 and 1,543 trades was sufficient. Likewise, in earlier decisions, the court opined that having $754,277 of gross trading proceeds in one year was insufficient to qualify for trader status, but gross trading proceeds of nearly $15 million was sufficient. (Fariborz Assaderaghi, TC Memo 2014-33.)
Traders are supposed to be in the continuous business of trading stocks. A multi-year 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.
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