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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 tax and accounting headaches that the average investor may find overwhelming.
In this article, we’ll 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. Like any investing activity, it makes sense to understand these issues to maximize any tax benefits that may be available.
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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.
Mark-to-market accounting is a method in which 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. This is done at the end of each tax year.
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 can’t use the preferable capital gains tax rates for long-term capital gains.
Wash sale rules apply 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.
Trading is classified as a business by the IRS — meaning those who participate, much like in any business, can deduct their operating costs.
For a trader, these might include:
Unlike other Schedule C taxpayers, the profits from trading are not subject to the self-employment tax — a tax consisting of Social Security tax and Medicare tax for those who work for themselves — which is a positive. The flip side is that traders cannot use this income as the basis for making business retirement plan contributions.
Being a day trader alone does not qualify you as having the tax status of a trader. The IRS considers you a trader if you meet several criteria it has established:
In addition, the IRS will look at the following factors to determine if your trading activity is a securities trading business:
While there are no definitive rules, examples of some criteria suggested by trader tax expert GreenTraderTax for qualifying as a trader include:
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.
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.
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.
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