Day Trading: Off-setting Capital Losses and Gains; Electing Mark-to-Market Accounting

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, April 30, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Question: As an internet stock trader, I made $2 million in short-term capital gains (STCG -- property held less than 12 months before sale) in 1999. I reinvested that cash, but lost all my funds on April 14, 2000, when the NASDAQ crashed and I was forced to sell because of margin calls (demand by a lender to repay amounts borrowed against a stock portfolio). Now I’m broke, but do I still owe IRS taxes for 1999?

Answer: Yes, and I suspect you are not alone. Many "day-traders," those who use the internet to execute stock trades on a daily basis for their own personal gain, are in for a rude tax surprise. Not only are their STCG taxed at ordinary income rates (as high as 45% for federal and California combined), short-term capital losses (STCL) incurred in the subsequent year do not offset gains for the prior year.

Capital gains and losses during each year are netted: If you have a net capital gain, you pay tax on the gain; if you have a net capital loss, you may carry forward the loss to future years. The loss is applied first against capital gains, and then up to $3,000 of ordinary income, per year.

Because of these rules, day traders with a large capital gain in one year and a loss the next face disaster – the loss does not offset the previous gain.

Example: Joe Smith had $1 million STCG with $200,000 of STCL in 1999. The net gain of $800,000 is taxed as ordinary income. Using a combined federal and California tax rate of 45%, Joe owes $360,000 ($800,000 gain x 45% = $360,000) on his gains.

However, in 2000, Joe has $50,000 STCG and $850,000 STCL, producing a net STCL of $800,000, wiping out his trading account. Joe cannot carryback any of his 2000 loss to 1999 to offset his 1999 taxable gain. Thus, he still owes $360,000 for 1999 taxes, but has no money to pay the taxes due. Instead, he may apply $3,000 of the STCL against his ordinary income in 2000 and must carry forward the $797,000 balance to future years. If Joe does not have capital gains in future years, he would exhaust this STCL in 265.67 years ($3,000/year x 265.67 = $797,000). Note: The STCL expires at death; it cannot be used by your heirs.

The lessons: You must thoroughly understand the tax consequences of day trading. Generally, avoid selling stock with gains at year’s end. If year-end gains are unavoidable, then consider selling your loss positions at year’s end to reduce the gains.

Finally, by all means set aside enough money to pay your taxes. Do not count on having Uncle Sam’s tax dollars in your trading account; otherwise, you’re flirting with financial ruin should the market turn against you.

Question: I’m a full-time day trader. Can I protect myself against the inability to offset gains with future losses?

Answer: Yes. Provided you qualify as a "trader" as opposed to an "investor," you may elect "mark-to-market" accounting by the due date of the previous year's tax return (with no extensions). Unfortunately, this remedy is not available for those with gains in 1999 and losses in 2000 because the time to elect expired on April 15,1999.

A trader is defined as someone whose full-time business activity is buying and selling securities for his own account as a continuous and frequent occupation. Traders must actively and continuously purchase and sell securities, devoting the same time and energy as to a full-time job, while concentrating on short-term swings in stock prices.

In contrast, investors focus on long-term capital appreciation and usually have another occupation or line of work. In general, a taxpayer who works a full-time job then trades stock before or after work will be classified as an investor. Note: The courts have not yet ruled whether a day-trader with another full-time job can attain trader status.

Note: A trader may engage in long-term stock purchases and sales, provided those securities are segregated from his daily trading account.

Even if you qualify for trader status, you may not offset capital gains with future capital losses unless you elect mark-to-market accounting for your trades. Then, your trades will be taxed as follows: (1) you recognize gains and losses at year’s end; and (2) gain or losses are determined and reported as though your stocks and securities were sold at fair market value on the last trading day of the tax year. In short, gains and losses are netted, whether or not the stock or security is actually sold, and the difference is reported as ordinary income or loss.

Under mark-to-market accounting, all gains and losses are taxed as ordinary income and reported on Form 1040, Schedule C, as a business activity; thus, the STCL rule limiting the loss to offsetting capital gains, plus $3,000 of ordinary income per year, does not apply.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.