Day trading — the buying and selling of a security within a single trading day — can be a profitable activity for experienced and skilled investors. However, this type of frequent trading also can trigger many tax and accounting headaches that can be overwhelming to the average investor.
We will take a look at some of the key tax issues associated with day trading and whether the Internal Revenue Service (IRS) might classify you as a trader for tax purposes.
How traders are defined
The IRS considers you a trader if you meet several criteria it has established:
- You look to profit from the daily price movements of securities versus from dividends, interest or capital appreciation from the securities.
- Your activity must be substantial in its eyes.
- You must engage in this trading activity on a continuous and regular basis.
In addition, the IRS will look at the following factors to determine if your trading activity is a securities trading business:
- Your typical holding period for the securities you buy and sell
- The frequency and dollar amount of your trades over the course of the year
- The extent to which you pursue this trading activity to produce income and a livelihood for yourself
- The amount of time you devote to your trading activity
While there are no definitive rules, examples of some criteria suggested by trader tax expert GreenTraderTax for qualifying as a trader include:
- You maintain sufficient trading volume — at least four trades per day, 15 per week or 60 per month.
- You earn a substantial amount of your income from trading.
- You trade on a regular and recurring basis.
- You execute a trade on at least 75% of available trading days during the year.
- Your average holding period for securities is less than 31 days.
- You demonstrate the intention to run a trading business as your principal means of earning a living.
- You are set up as a business.
If your trading activities don’t meet the criteria outlined above, you likely are considered an investor in the eyes of the IRS.
Per the IRS definition, investors typically buy and sell securities with the expectation of earning income from dividends, interest or capital appreciation on those securities. Being a day trader alone does not qualify you as having the tax status of a trader.
4 tax reduction strategies for traders
Whether you are classified as a trader or an investor matters from a tax standpoint. Traders are in a position to reduce their taxes through a number of special benefits that can be maximized.
1. You can use mark-to-market accounting for your investments
This is done at the end of each tax year. You report gains and losses as if you sold everything on the last day of the year, which means you mark the securities held to the end-of-the year market value.
The benefit is that net trading losses can be deducted against other income on an unlimited basis. You are not limited to $3,000 in excess of capital gains, unlike taxpayers who are classified as investors. Mark-to-market traders begin the new tax year with a “clean slate.” In other words, all positions have zero unrealized net gains or losses. On the flip side, traders may not use the preferable capital gains tax rates for long-term capital gains.
2. A trader is exempt from wash-sale rules
This rule applies to investors who engage in the practice of tax loss harvesting, where investors sell securities to realize a loss but are prohibited from buying that same (or a similar) security within 30 days of the sale. Traders can realize losses and then immediately turn around and buy the same security they had sold.
3. Traders can deduct the expenses involved in their trading activities
Traders are classified as a business by the IRS, meaning they (much like any business) can deduct their operating costs.
For a trader, these might include:
- A home office deduction for your business activities, subject to IRS rules
- The cost of your computers, digital devices and internet access
- Subscriptions to trading services or journals
- Office supplies
- Costs related to outside accounting and tax services
- Interest expenses for margin loans and other debt used in trading activities
4. A trader is not subject to the self-employment tax
Unlike other Schedule C taxpayers, the profits from trading are not subject to the self-employment tax, which is a positive. The flip side is that traders cannot use this income as the basis for making business retirement plan contributions.
Differences in tax treatment for traders and investors
As an investor, you cannot deduct the expenses incurred in your trading and investing activities except within the confines of what any individual investor can do.
- Short-term gains are taxed as ordinary income.
- Long-term gains (defined as securities held for at least a year) are taxed at the more preferential long-term capital gains rates. This can be advantageous for those who hold securities for a sufficient time, but it is not a benefit for frequent traders with generally short holding periods.
- You no longer can deduct miscellaneous expenses. Prior to the tax reform enacted at the end of 2017, if you itemized, you were able to deduct your interest expense if you used margin debt to purchase securities, subject to the limitations in the rules.
Additionally, you will need to track the cost basis of all securities purchased in order to properly account for gains and losses when filing your taxes. If you are a day trader and trade frequently, then this requirement can be a real burden.
By contrast, if you are a trader, your trading activities are classified as a business. You can account for these as a sole proprietor, an S-corp, an LLC or another type of business entity that may be appropriate for your situation.
Like any investing activity, it makes sense to understand all the tax and accounting issues associated with day trading to maximize any tax benefits that may be available. Be sure to consult with a qualified tax or legal advisor if your goal is to have the IRS classify you as a trader.