Tax Strategies for Traders

If you're an active trader, taxes aren't often at the top of your mind, as you're likely focused on fine-tuning your trading strategy to maximize profits. However, as a trader, there are several unique tax strategies you should consider that could potentially lower your taxes and leave you with more money. Let's look at the tax implications of being a trader and some ways to use the tax code to your advantage.

As with many things, the IRS has its own language when it comes to traders, which can often confuse people. The IRS has three basic categories a trader can fall into: 

1. Investor: This is the default tax status for most people, even if you day trade.
2. Trader tax status: Often referred to by the IRS as a "trader in securities," this tax status can offer additional tax deductions, but you need to meet certain requirements to qualify for this. 
3. Trader tax status with a mark-to-market election: If you qualify for the trader tax status, you have the option to make a section 475(f) mark-to-market election, which potentially can offer additional tax benefits.

You may consider yourself a trader, but unless you meet certain requirements, the IRS will treat you as an investor for tax purposes. If the IRS sees your trading as investing, albeit on a very short-term basis, you'll be subject to the same tax rules that cover all other investors. In general, your trading will be taxed as follows:

• Capital gains are taxed at the short-term or long-term rates depending on how long you held the investment, and the 3.8% net investment income tax (NIIT) could also apply.
• Capital loss can be used to offset other capital gains and up to $3,000 of ordinary income. Any unused losses get carried forward to offset future capital gains or ordinary income.
• The wash sale rule may apply to your capital losses, which means you may not be able to claim a current year deduction for a loss if this rule applies.
• Trading expenses deductions are generally limited to trading costs and are added to the cost basis of your investments. You normally cannot deduct other trading costs like conferences, advice, training, or software.

Like all other taxpayers, a trader classified as an investor reports all capital gains/losses on a Schedule-D (Form 1040) or Form 8949. 

If your trading meets certain requirements, you may be able to claim the trader tax status, which can offer one potentially big tax advantage over being treated as an investor. By qualify for this status, you may be able to deduct many expenses not available to a normal investor. Examples of deductions include:

• Office space or home office deduction
• Computer, furniture, and other items used in your trading office
• Software used for trading 
• Market date services
• Education and conference expenses
• Any many other expenses related to your trading activity

The reason the IRS allows those who qualify for the trader tax status these additional deductions is because they're considered being in the business of trading. To the IRS, your trading is now seen in a similar way to most other businesses out there, allowing you to take a deduction for many "ordinary and necessary" expenses incurred to help you operate a successful trading business (see the IRS Publication 535 to learn more about common business expenses). 

To claim these business deductions, you'll need to either include them on a Schedule-C business return within your Form 1040 or have a separate entity that files a business return (like an S-Corp. or LLC). Check out Starting a Business? Determine Which Structure Is Right for You to learn various business types and pros and cons of each.

Even though the IRS now sees your trading as a business, that does not mean all income and expenses are reported on a business tax return. Those who qualify for the trader tax status still report all income and direct trading costs just like a normal investor. That means all trading costs are still included in your cost basis of the investment and all capital gains/losses are still reported in a Schedule-D (Form 1040) or Form 8949. 

Unfortunately, qualifying for the trader tax status is not always easy because there is not bright-line that says you qualify for this status. You'll have to weigh the facts and circumstances of your situation to see if claiming the trader tax status makes sense and is defensible if the IRS were to audit you. You should consider the following:

• The typical holding period for securities bought and sold.
• The frequency and dollar amount of trades.
• The extent the trading provides income.
• The amount of time devoted to trading.

Because the decision as to whether you qualify for the trader tax status is a bit vague, we highly recommend working with a tax professional who is experienced with this tax rule before filing a tax return that claims this status.

If you qualify for the trader tax status, you may want to consider if making an election under section 475 of the tax code to mark-to-market all your trades could help you save on taxes. This election is not for everyone, but it can offer additional tax benefits in the right situation. Just be aware, if you make this election, you can only undo it with permission from the IRS.

The primary benefit of making this election is that you no longer have to worry about the wash sale rule and any trading losses you generate are treated as a business loss, which means those losses can offset your ordinary income without the normal $3,000 annual limit. In addition, all gains, losses, and expenses are reported in a business tax return (e.g., schedule C).

However, those tax benefits do have a cost, and you'll be required to realize all gains and losses at year-end, no matter if you sold the investment or not. Because you mark-to-market all trades at year-end, the cost basis of all assets are also adjusted to match the market price at the end of the year. That way, any future gains and losses in the following year will account for the fact that you already realized a portion of the trade in the prior year. 

To make the mark-to-market election, you'll need to file Form 3115 (Application for Change in Accounting Method). IRS Publication 550 describes the procedures in making this election with the IRS.

No matter how you decide to apply the rules above, remember, these rules only apply to your trading activities in a taxable brokerage account. If you have other investments that are not traded, held in other accounts, or are for retirement, then those assets will be converted by the normal investment tax rules. 

We've only scratched the surface when it comes to taxes and traders. To learn more, see IRS Topic 429. As with all tax topics, before making a decision, we recommend meeting with a tax professional. They can help you better understand unique tax considerations and potential advantages or disadvantages for full-time trading as well as file any needed documentation with the IRS.