Chapter 17
IN THIS CHAPTER
Understanding the rules for different trading products
Hiring a savvy tax adviser
Figuring incoming income and outgoing expenses
Divulging tax secrets for IRS-qualified traders only
Reporting to the IRS and paying estimated taxes
Paying into retirement accounts
Think day trade returns come without a catch? Think again, because the IRS has plenty of ways to catch you come April 15. Day trading involves strategies that generate both high returns and high tax liabilities, which can eat away at your total return if you’re not careful. Not all your expenses are deductible, and although you may think that you’re day trading, the IRS may have a different definition of your activities.
Taxes themselves aren’t necessarily bad, because citizens have to pay for things like roads and schools and national defense somehow. But taxes can be devastating to your personal finances if you haven’t planned for them. You need to consider the tax implications of your trading strategy right from the start and keep careful records so that you’re ready.
The Internal Revenue code is complex, with specific rules for specific types of transactions. You can easily get tripped up, and a tax trip-up can be costly. Here I give an overview of different types of day trading assets and some of the tax implications associated with them.
Of the many reasons that day traders work with commodity and futures contacts, one is that the taxes are easy to handle. Under Section 1256 of the IRS code, certain types of contracts — for example, regulated futures contracts, foreign currency contracts, and non-equity options (on debt, commodities, currencies, and stock market indexes) that are marked-to-market in trading — are handled under the 60/40 rule. This rule stipulates that 60 percent of your total capital gain or loss will be treated as a long-term capital gain or loss, and the other 40 percent of your gain or loss will be treated as a short-term gain or loss. How long you held the position doesn’t matter. Why is this rule so nice? Because the long-term capital gains rate is less than the short-term rate, and you as a day trader can take advantage of it, even though, by definition, day traders don’t hold positions over the long haul.
If you trade currencies, the tax laws that apply to you can be confusing, and they have gray areas. The following can impact how taxes apply to you:
Whether you’re an individual or a business: Small individual currency transactions are usually considered to be like-kind exchanges; for example, if you go on vacation to Mexico, exchange your dollars to pesos when the dollar is strong, and then change whatever remains back at the border a week later when the dollar is a bit weaker, you’ll have made a profit. However, this transaction is not a reportable one, because, in essence, you exchanged two identical items: money for money.
A business, however, can accrue taxable gains and losses due to changes in exchange rates. If a company makes goods in the United States and sells them through its Mexican subsidiary, for example, the amount of profit or loss that the subsidiary has depends on the exchange rate between the dollar and the peso, and that determines the amount of tax that the company pays. In this case, identical objects aren’t being exchanged. (The IRS has plenty of rules on how businesses should handle foreign exchange under Section 988 of the tax code.)
Whether you’re trading actual currency or futures and options on currencies: Futures and options on currencies are taxed under Section 1256 using the handy 60/40 rule described in the preceding section. But you’re trading in the spot market. You aren’t trading currency contracts; you’re trading actual currency. What do you do about profits and losses you may accrue?
The IRS isn’t keen on your claiming a tax-free like-kind exchange if your goal is to make a living trading currencies. But you aren’t running a business with overseas operations, are you? Unfortunately, there are no clear guidelines here, so you probably want to work with an accountant. The general thought is that you can report your currency trading through Section 988 or Section 1256. Under Section 988, your trading gains and losses are considered short-term capital gains in your trading business. This arrangement saves you money if you lost money trading but costs you if you made money. Under Section 1256, your spot trading is handled as futures contracts, and you pay short-term capital gains taxes on 40 percent of your profits and long-term capital gains taxes on the remaining 60 percent of your profit. This saves you money in the years you made money.
The key? Be consistent. You can’t file under Section 988 when you lose money and under Section 1256 in years you make money. That game makes the IRS very unhappy, and you don’t want to have the tax guys unhappy with you.
The taxation of options is more complicated than the taxation of other derivatives. The basic information is the same: A gain on an option held for less than a year is a short-term capital gain, and a gain on one held for more than a year is a long-term capital gain. There are two problems, though. The first is that some options strategies offer a combination of short-term and long-term gains and losses. The second is that options trades fall under the wash-sale rule (explained later in this chapter), which limits your ability to make trades of fewer than 30 days in the same securities.
Options have one other wrinkle: You can’t use options to manage taxable sales and gains in stocks. An option on a stock is considered to be substantially identical to the stock. That’s why the tax treatment is pretty much the same — and why professional tax advice is really important if you’re trading options.
In Chapter 2, I cover the differences between investing, trading, and gambling. Day traders aren’t investing; they’re looking to take advantage of short-term price movements, not to take a stake in a business for the long term. Unless, of course, you’re asking the IRS about it. The IRS defines trading much differently than people in financial circles do. To the taxmen, you are a trader only if all of the following apply to you:
IRS Tax Topic 429 covers the matter in more detail. If you trade part-time, have other employment, or are new to the day trading game, the IRS probably won’t let you define yourself as a trader. Don’t care what an IRS agent calls you, as long she doesn’t call you for an audit? Well, understanding the difference between trader and investor in IRS lingo is important to avoid that audit.
You don’t have to hire someone to do your taxes, but you probably should. Day trading generates a lot of separate transactions to track, and the tax laws are tricky. Mistakes can end up costing you your entire trading profit.
Okay, you’re waiting for me to say there’s only one flavor of accountant, and it’s plain vanilla, right? Wrong. Tax experts fall into several different categories, and knowing which is which can help you determine who is best for you:
After you identify a few prospective candidates to prepare your taxes, talk to them and ask them questions about their experience. You want someone who understands things such as the wash-sale rule (which can limit the deductibility of your losses and is covered in more detail in the later section “Understanding the wash-sale rule”) and the mark-to-market election (which can allow you to deduct more losses; see the section “Mark-to-market accounting”) and who can help you determine what you owe in taxes and not one penny more.
Here some things you should ask a potential tax preparer:
Traders can do their own taxes. If you are comfortable with tax forms, if you are only day trading a little bit, and if I haven’t deterred you yet, you may be able to handle your own taxes. Here’s what you need: the proper IRS forms and tax preparation software that can handle investment income.
The IRS website, www.irs.gov
, is a treasure trove of tax information. All the regulations, publications, forms, and explanations are there, and some of it is even in plain English. The site is so vast and detailed that you’ll probably be overwhelmed (I’m not sure there is any page in any IRS publication that doesn’t mention dividends received under the State of Alaska Permanent Fund).
The brave people who do their own taxes know that tax-prep software is a godsend, and it’s even more valuable for those do-it-yourselfers who trade a lot. The software fills out the forms, automatically adds and subtracts, and even catches typographical errors. In many cases, it can download data straight from your brokerage account, making data entry really simple.
Most of the big brands, such as TaxCut and TurboTax, publish several editions each year — not all of which are set up to import and manage lots of trading data. Among those that have services for investors are TurboTax Premier Investments (www.turbotax.com
), H&R Block at Home Premium (www.hrblock.com
), and CompleteTax (www.completetax.com
).
Income seems like a straightforward concept, but not much about taxation is straightforward. To the IRS, income falls into different categories, with different tax rates, different allowed deductions, and different forms to fill out. In this section, I cover income definitions you’ll run into as a day trader.
Earned income includes wages, salaries, bonuses, and tips. It’s money that you make on the job. But even if day trading is your only occupation, your earnings aren’t considered to be earned income. Therefore day traders, whether classified for tax purposes as investors or traders, don’t have to pay the self-employment tax on their trading income. Isn’t that great?
Well, maybe, maybe not. The self-employment tax, the bane of many an independent business person, is a contribution to the Social Security fund. (Employees pay half of the contribution, and the employer pays the other half. The self-employed have to pay the whole thing.)
The problem is that if you don’t have earned income, you are not paying into Social Security. If you are not paying into Social Security, you may not be eligible for retirement benefits. To collect benefits, you have to have paid in 40 credits, and you can earn a maximum of four credits per year. Most employees do this easily, but if you’ve taken time off work or have a long history of work as an independent investor, you may not have paid enough in.
Investment income is your total income from property held for investment before any deductions. It includes interest, dividends, annuities, and royalties. Investment income does not include net capital gains, unless you choose to include them. Do you want to include them? Well, read the next section.
Other than net capital gains, which you may or may not decide to include, most day traders have very little investment income for tax purposes.
A capital gain is the profit you make when you buy low and sell high — the aim of day trading. The opposite of a capital gain is a capital loss, which happens when you sell an asset for less than you paid for it. Investors can offset some of their capital gains with some of their capital losses to reduce their tax burden.
Capital gains come in two flavors: short term and long term. You’re charged a low rate (the current rate is 15 percent) on long-term capital gains, which right now is defined as the gain on assets held for more than one year. Short-term capital gains, which are those made on any asset held for one year or less, are taxed at the ordinary income rate, probably 28 percent or more.
Capital gains and losses are calculated using a security’s basis, which may or may not be the same as the price that you paid for it or sold it at. Some expenses, such as commissions or disallowed wash-sale losses (both of which are discussed later in this chapter), are added to the cost of the security, and that can reduce the amount of your taxable gain or increase the amount of your deductible loss.
For example, if you bought 100 shares of stock at $50 per share and a $0.03 per share commission, your basis would be $5,003 — the $5,000 you paid for the stock and the $3 you paid in commission.
Suppose you love LMNO Company, but the price of the shares is down from what it was when you purchased them. You want to get that loss on your taxes, so you sell the stock, and then you buy it back at the lower price. You get your tax deduction and still keep the stock. How excellent is that?
It’s too excellent to be true. This trick is called a wash sale, and the IRS does not count the loss. The wash-sale rule was designed to keep long-term investors from playing cute with their taxes, but it has the effect of creating a ruinous tax situation for naïve day traders.
Under the wash-sale rule, you cannot deduct a loss if you have both a gain and a loss in the same security within a 61-day period. (That’s calendar days, not trading days, so weekends and holidays count.) However, you can add the disallowed loss to the basis of your security.
Here’s an example to illustrate. On Tuesday, you bought 100 shares of LMNO at $34.60. LMNO announced terrible earnings, and the stock promptly dropped to $29.32, and you sold all 100 shares for a loss of $528. Later in the afternoon, you noticed that the stock had bottomed and looked like it might trend up, so you bought another 100 shares at $28.75 and resold them an hour later at $29.25, closing out your position for the day. The second trade had a profit of $50. You had a net loss of $478 (the $528 loss plus the $50 profit). Here’s how this works out tax-wise: The IRS disallows the $528 loss and lets you show only a profit of $50. But it lets you add the $528 loss to the basis of your replacement shares, so instead of spending $2,875 (100 shares times $28.75), for tax purposes, you spent $3,403 ($2,875 plus $528), which means that the second trade caused you to lose the $478 that you added back. On a net basis, you get to record your loss. The basis addition lets you work off your wash-sale losses eventually, assuming that you keep careful records and have more winning trades than losing ones in any one security.
The wash-sale rule applies to substantially similar securities. LMNO stock and LMNO options are considered to be substantially similar, so you can’t get around the rule by varying securities on the same underlying asset. LMNO shares and shares of its closest competitor, PQRS, would probably not be considered substantially similar, so you can trade within a given industry to help avoid wash-sale problems.
At an extreme, the wash-sale rule can mean that traders who are in and out of the same securities over and over may be taxed on all their winning trades, without being able to subtract their losing trades for tax purposes. If your winning trades gained $300,000, and your losing trades cost you $200,000, you cleared $100,000 — but the IRS may tax you on the $300,000. Ouch!
Miscellaneous income is money that you received that wasn’t earning income, investment income, or capital gains. This kind of income is often payment received in the course of a business or trade. As a freelancer, most of my income is reported to the IRS in the miscellaneous category. Anyone who pays me for my services has to send me Form 1099-Misc at the end of the year, with a copy going to the IRS, to help the agency track my earnings. Some proprietary traders that provide services for day traders (covered in Chapter 11) report your profits and losses on Form1099-MISC. Miscellaneous income is handled as self-employment income and must be reported.
Day traders have expenses. They buy computer equipment, subscribe to research services, pay trading commissions, and hire accountants to prepare their taxes. It adds up, and the tax code recognizes that. That’s why day traders can deduct many of their costs from their income taxes. In this section, I go through some of what you can deduct.
You can deduct investment expenses as miscellaneous itemized deductions on Schedule A of Form 1040 as long as these expenses are ordinary, necessary, directly related to the taxable income produced, and used to produce or collect income or manage property held for producing income. By the way, writing off these expenses only makes sense if you have more than $12,000 in expenses as an individual or $24,000 as a married couple.
You may use the services of a lawyer to help you get set up, and you will almost definitely want to use an accountant who understands investment expenses to help you evaluate your trading strategy and prepare your state and federal income tax returns each year. There’s good news here: You can deduct attorney and accounting fees related to your investment income. If your trading operation gets big enough that you hire clerical help to keep track of all those trade confirmations, you can deduct that cost, too.
If you do your day trading from an outside office, you can deduct the rent and related expenses. You can deduct the expenses of a home office, too, as long as you use it regularly and exclusively for business. If your trading room is also the guest room, it doesn’t count.
Whether or not you deduct your office, you can deduct certain office expenses for equipment and supplies used in your business. You can usually write off roughly $100,000 in computers, desks, chairs, and the like if you use them for trading more than half of the time. (The limits change every year.)
The IRS allows you to deduct fees paid for counsel and advice about investments that produce taxable income. This advice includes books, magazines, newspapers, and research services that help you refine your trading strategy. It also includes anything you may pay for investment advisory services, such as trade coaching or analysis.
By the way, you can probably deduct what you paid for Day Trading For Dummies. Did you save the receipt?
Have a safe-deposit box down at the bank? You can deduct the rent on it if you use it to store investment-related documents. If you also keep jewelry that you inherited and never wear or other personal items in the same box, you can only deduct part of the rent.
If you borrow money as part of your strategy, and most day traders do, you can deduct the interest paid on those loans as long as it is not from a home mortgage (because that interest is already deductible) and as long as you are not subject to other limitations set forth in the IRS code, such as the Alternative Minimum Tax. There’s always a catch, isn’t there? In most cases, the catch is margin interest (see Chapter 5 for more information on margin). For most day traders, margin interest is relatively small because few day traders borrow money for more than a few hours at a time.
If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income. In most cases, exempt income is related to government bond transactions, and few day traders work in those markets.
As you day trade, you’ll probably incur expenses that can’t be deducted from your taxes. Disappointing, I know, but if you know what these nondeductible expenses are upfront, you can plan accordingly.
Every time you make a trade, you have to pay a commission to your broker. It may be small, just a few cents per share or a few dollars per trade, but you have to pay it. And you can’t deduct that cost.
Before you splutter in outrage, read this: You can’t deduct it, but you can add it to cost and subtract it from the proceeds of your trade. Here’s an example: You buy 100 shares of QRS Corp. at $29.40 per share, paying a $6.00 commission on the trade. Your total cost for IRS purposes is ($29.40 × 100) + $6.00, which equals $2,946. Later in the day, you sell all 100 shares for $30.00 per share at a $6.00 commission, so your total proceeds for the deal are ($30.00 × 100) – $6.00, or $2,994. Your total profit for tax purposes is $2,994 – $2,946, or $48.00.
If your state charges transfer taxes on securities, they are handled the same way as commissions.
Companies hold annual meetings for their shareholders, usually at or near the company headquarters. Sometimes these meetings are deathly dull: The board of directors sits around a conference room in a law office and goes through a boilerplate agenda with nothing to discuss. Others are extravaganzas where the company shows off new products, showcases major accomplishments, and takes questions from anyone in attendance. And a few involve contentious issues that can lead to protests and fighting, which is entertaining to watch if you aren’t directly affected.
For long-term investors, these meetings can offer valuable insights on a company’s prospects. Day traders probably wouldn’t find them very useful, and it’s just as well, because the IRS won’t let anyone deduct the costs of transportation, hotel stays, meals, and other expenses that may be involved in attending a stockholders’ meeting.
The financial-services industry offers all kinds of conventions, cruises, and seminars for day traders. You can spend your days attending training seminars instead of actually trading, if you’re so inclined. You’re welcome to go to these, and in many cases, you should. You may discover things that would help you trade more effectively. However, you can’t deduct the costs. Bummer.
You didn’t think the IRS would let you take all your deductions automatically, did you? Of course not. Your deductions may be limited, especially if you don’t meet the IRS definition of trader.
The IRS says that your loss is limited by the amount of property you contribute to your investing activities, including money you borrow. In most cases, day trading losses meet the risk definitions, but if you pursue a naked trading strategy that causes you to lose more than your initial investment, you may fall into this category.
The IRS defines a passive activity as an investment where the investor does not play an active role but does make money. You can deduct passive activity losses only up to the amount of your passive activity income, and you can use credits from passive activity losses only against tax on the income from passive activities. Day trading is generally considered to be active, because you are materially participating, but if you are generating passive losses from other investment activities, you probably won’t be able to use them to offset your day trading gains.
The IRS allows you to deduct investment interest up to the amount of your net investment income, which is your investment income less all your allowable deductible expenses except for interest. If you lost money trading, you can’t use the interest deduction to reduce your taxes. What you can do, though, is carry the undeducted investment interest into next year and use it to reduce your taxes on those profits.
You also can’t deduct interest expenses on straddles. A straddle is an options strategy that involves buying both a put option and a call option on the same stock with the same strike price and expiration date. In most cases, the nondeductible interest and related carrying charges are added to the basis of the straddle (just as commissions are — see the earlier section “Calculating capital gains and losses: Covering all your basis”).
If you do not qualify as a trader to the IRS, you can deduct investment expenses and other miscellaneous itemized deductions only if they add up to more than 2 percent of your adjusted gross income.
If you meet the IRS qualifications for being a trader (see the earlier section “Stock trading”), you can avoid some of the tax headaches faced by people who trade but are not considered by the taxman to be traders. If you trade as your job, make thousands of trades a year, and rarely hold any position for more than a day, then you can fill out something called Form 3115, Application for Change in Accounting Method, and tell the IRS that you want to use the mark-to-market election in calculating your capital gains and losses. Form 3115 isn’t an easy form to fill out, so you should have a professional do it for you.
The form has to be submitted with your prior year’s tax return. If you want to use mark-to-market accounting in 2019, for example, you need to submit Form 3115 when you send your 2018 tax return in April 2019.
If you qualify for trader status, you receive two benefits: mark-to-market accounting and increased expense deductions. I cover both in the following sections.
Under mark-to-market accounting, you no longer have to track capital gains. Instead, you pretend to sell your portfolio at the end of the year and then pretend to repurchase everything at the beginning of the new year so that all capital gains fall into income.
Because day traders usually close all their positions at the end of the day anyway, mark-to-market accounting may not seem like a big deal, but it is: In effect, converting all capital gains to income means that your trades are no longer subject to the wash-sale rule. For most day traders, this lowers taxes and results in fewer paperwork hassles.
In general, the IRS allows investors to deduct business expenses only if these expenses exceed the $12,000 single/$24,000 married standard deduction. However, anyone who gets to join the charmed circle of IRS-qualified traders gets to deduct 100 percent of expenses, regardless of their adjusted gross income. They get to deduct all their investment interest, too.
One caveat, though: The IRS assumes that people are in the business of trading because they are making money at it. If you lose money for three out of five years, even if it’s because your expenses exceeded your investment profits rather than due to trading losses, the IRS will probably kick you out of the club.
Knowing what constitutes income, what expenses you can deduct, and what special rules apply if the IRS considers you a qualified trader is all well and good, but when it comes right down to it, you still need to know the more mundane things like what tax forms to fill out and when they’re due. This section has the details.
Many of the differences in income and expenses discussed already in this chapter make more sense when you think about how they are reported on your income tax return. In this section, I give you the highlights of some of the most exciting forms for the modern day trader. Note that they are different for those who qualify as traders by IRS standards (refer to the earlier section “Stock trading”) than for everyone else who day trades.
If you have been an employee for years and years, all your tax liabilities may have been covered by your payroll tax deductions. The IRS likes it best that way, because then it gets money all year round. Face it: the easier it is to pay, the more likely you are to do it.
People who are self-employed or who have significant earnings from investments and day trading may generate more income than can be covered from payroll withholding. What you need to do is estimate your tax liability four times a year and then write a check for those amounts. (Otherwise, you could face a penalty at tax time.) Estimated taxes are paid on Form 1040 ES and are due April 15, June 15, September 15, and January 15.
Much of the tax hassle associated with day trading is eliminated if you trade through a self-directed individual retirement account, or IRA. Most brokerage firms can set them up for you and handle the necessary paperwork. Although individuals can contribute only $6,000 per year ($7,000 for people older than 50), the money can be substantial for those who have been contributing for a long time. Also, you can roll over money from an employer’s retirement plan, such as a 401(k), into an IRA after you leave.
You don’t have to pay taxes in an IRA until you retire, and then withdrawals are generally treated as ordinary income. For this reason, an IRA is a great vehicle for day traders: You can post big gains, count all your losses, and avoid wash-sale rules for trading within your IRA. It’s a sweet way to let your profits accumulate and compound for years. Of course, there’s a catch: You can’t sell short, you can’t use all options strategies, and your brokerage firm may not want to clear funds through the IRA.