Taxation of Day Traders

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, April 25, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

Taxation of Day Traders

The Internet has spawned a burgeoning class of investors who use their computers to execute stock trades on a daily basis for their own personal gain ("day traders"). Most day traders hold their positions just a few hours or days, looking for a quick profit on minor price fluctuations.

The tax issue is whether the person is actually in a full-time business of trading stocks -- a "trader in securities" ("Trader") -- or an investor who purchases and holds stocks for appreciation ("Investor").


Distinguishing Between Traders and Investors

To attain Trader status, the courts have required proof of full-time business activity where the taxpayer buys and sells 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 a full-time job and 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: A Trader may engage in long-term stock purchases and sales, provided he segregates those activities from his daily trading.


Taxation of Short-Term Capital Gains and Losses

Stock purchased and sold for a profit within 12 months is subject to the short-term capital gains ("STCG") rules; the profit is taxed as ordinary income. Similarly, stock sold for a loss is subject to the short-term capital loss ("STCL") rules. At year’s end, STCG and STCL stocks are netted. Gains are taxed at ordinary-income rates.

Unfortunately, if there is a net loss, STCL rules limit it to a maximum of $3,000 ($1,500 for married filing separately) in any single tax year; the balance is then carried forward. Because capital losses can only be carried forward, the taxpayer must make profits in future years to off-set the losses above $3,000 per year

Example: Joe Smith has $100,000 STCG with $40,000 of STCL in 1998. The net gain of $60,000 is taxed as ordinary income. However, in 1999, Joe has $40,000 STCG and $100,000 STCL, producing loss of $60,000. Joe cannot carryback his 1999 loss to 1998 to offset the taxable gain in that year. Instead, he receives a $3,000 ordinary loss in 1999 and must carry forward the $57,000 balance to future years. If Joe does not have gains in future years, he would exhaust his STCL in 19 years ($3,000 year x 19 = $57,000).


Deductibility of Stock-Related Expenses

Both Traders and Investors may deduct expenses associated with their investment activities (computers, Internet-access costs, library expenses and investment advice). However, an Investor may deduct these losses as an itemized miscellaneous deduction on Form 1040, Schedule B, which means (1) he must itemize deductions and (2) the deduction amount is only for expenses exceeding 2% of the taxpayer’s adjusted gross income ("AGI").


Electing "Mark-to-Market" Accounting

A recent tax change allows Traders to elect "mark-to-market" accounting so that securities may be taxed as follows: (1) the Trader recognizes gains and losses on securities at year’s end; and (2) gain or loss is determined and reported as though the security were sold at the fair market value on the last day of the tax year. In short, gains and losses are netted, whether or the stock is actually sold, and the difference is reported as ordinary income or loss.

Because the securities are capital assets, gains are not subject to self-employment tax. Mark-to-market may be elected on Form 3115. Once elected, can be revoked only with IRS permission.

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

Example: During tax year 1998, Joe Smith, as a Trader, had $200,000 of STCG and $300,000 of STCL. If Joe failed to elect mark-to-market accounting, he would report his gains and losses on Schedule D. His net STCL would be $100,000. Joe could deduct $3,000 in 1998 as an ordinary loss and carry forward $97,000 in losses to future years.

In contrast, if Joe elects mark-to-market treatment, his 1998 $100,000 STCL is reported on Schedule C as an ordinary loss and applied to other income earned in 1998. Furthermore, under the net operating loss rules, Joe could carry forward the unused loss for 20 years, or carry it back 2 years, then forward from that point (subject to the 20-year carryforward limitation).


Conclusion

With day trading, tax status is everything. Traders enjoy the full deduction of expenses and ability to elect mark-to-market accounting. Trader status, however, requires a full-time commitment to trading stocks for short-term gains.

The lesson: Unless you trade stocks full-time, pay strict attention to your stock losses, particularly if you’re assuming those losses are fully deductible. Otherwise, you may need to work even harder at your other day job just to break even.




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