And speaking of government rules that are hard to interpret, try qualifying as a trader:
Taxing Situations
By Michael Sincere
services100.members.fidelity.com
Tax Strategies for Active Traders
You may not have given much thought to how often you trade
stocks, but the Internal Revenue Service has. The IRS makes a
distinction between traders and investors – and treats them very
differently come April 15. In fact, traders may be eligible for tax
breaks and other advantages that are not available to investors.
Are you a trader or an investor?
While you may consider yourself an active trader, the IRS may
take a different view. Before you can qualify for any of the tax
breaks the IRS doles out to traders, you need to determine
whether you qualify as an "investor" or "trader" under IRS rules.
Unfortunately, there are no clear-cut official guidelines from the
IRS to help you determine your status. The best way to decide
your status is to rely on guidance provided by historical tax court
case rulings.
Generally, the courts have ruled that you may be considered a
trader if you can meet all of the following criteria:
You spend a lot of time trading. You can have income
from other sources besides trading, but if you have a
full-time job, especially if it's during the hours that the
stock market is open, the IRS would probably challenge
your filing status as a trader.
You trade on a frequent and continuous basis. If you only
make a few trades a week, you probably will not qualify
for trader's status.
You take a short-term view of buying and selling. The
courts seem to agree that traders buy stocks with the
intention of making a profit from short-term market
swings. If you hold your stocks for longer periods, a court
will be less likely to conclude that you're a trader.
Despite tax court rulings, it can still be difficult to assess the
IRS distinctions between traders and investors. For example,
IRS regulations do not provide clear guidance as to the number
of trades that qualify an individual to claim trader status.
Furthermore, the rules don't tell you how much time you need to
spend on trading to be considered a trader. In essence, it's left
up to the taxpayer to determine whether he or she can support a
claim of being a trader. If the IRS challenges your claim, the
burden of proof is yours. That's why it may be well worth the time
and money to seek the advice of a skilled tax accountant or
attorney who can review the current court rulings, and help you
decide if you're a trader or an investor.
What's so great about being a trader?
If you qualify as a trader according to tax law, one significant
benefit is that the IRS considers you to be self-employed. As a
result, you can file Schedule C (Profit or Loss from Business)
with your annual tax return. When you use Schedule C, you can
deduct 100% of your legitimate trading expenses, including
margin account interest. Deductible business expenses can
include computer equipment, magazine subscriptions, ISP
charges, data line feeds, or home office expenses.
By contrast, for investors, expenses fall into the "miscellaneous"
category, and must be reported on Schedule A. Any investment
expenses can be combined with expenses such as tax
preparation fees or safe deposit box rentals, and can be
deducted only if the expenses exceed 2% of adjusted gross
income.
Both traders and investors report trading gains and losses on
Schedule D, Form 1040. Both can deduct no more than $3,000
in net capital losses each year. However, if you're a trader, the
expense write-offs available with Schedule C may reduce your
adjusted gross income, which in turn, may qualify you for other
income-sensitive deductions and lower overall taxes. Schedule C
filers don't need to worry about self-employment taxes, either.
The IRS says that there is no self-employment tax due from net
income on trading, whether you use Schedule C or D, unless
you own a seat on a national stock exchange.
Mark-to-market accounting (MMA)
Traders have another advantage over investors: Under Internal
Revenue Code Section 475, traders can choose to elect an
accounting method called mark-to-market accounting (MMA).
This accounting method may provide additional tax advantages.
Here's how it works: On the last trading day of the year, you
treat all your holdings as if you sold them at fair market value. In
other words, all positions are "marked to market" at the year-end
fair market value. You still own the stocks, but you calculate the
gains or losses on paper as of that day for tax purposes.
By using mark-to-market accounting, your trades generate
ordinary income or losses rather than capital gains or losses. All
transactions are reported on Form 4797, Part II, (Ordinary Gains
and Losses), instead of Schedule D (Capital Gains and Losses).
By doing this, winning trades are considered ordinary income
and losing trades are considered losses that can be deducted
from your income.
In addition, when you choose to be a mark-to-market trader, you
are no longer limited to $3,000 a year in net capital losses.
Mark-to-market traders can deduct an unlimited amount of
losses, which could be a significant benefit in a bear market.
Mark-to-market traders are also exempt from the wash sale rule,
which can be an accounting nightmare for traders. The wash
sale rule prevents investors from deducting a loss on a security
that is sold and then repurchased within the 61-day window
beginning 30 days before the sale and ending 30 days after the
sale. It was designed to discourage investors from selling a
losing stock, claiming a deduction on the loss, and then
repurchasing the same stock shortly thereafter.
Proceed with caution
While becoming a mark-to-market trader sounds appealing,
there are a couple of important negative aspects to choosing
MMA. Once you select this accounting method, you are stuck
with it as long as you continue to be a trader. You can change
the election only with the written permission of the IRS, which
might not be too agreeable if your only reason for changing is
that the MMA election is no longer beneficial for you.
Another negative aspect of using MMA is that you can't carry
over any net capital losses incurred in previous years. These are
only deductible against capital gains. Once you switch to MMA,
all your future profits will be treated as ordinary income, and you
won't be able to deduct your losses unless you have other
sources of capital gains.
If you decide to use the mark-to-market accounting method, you
must officially notify the IRS of your election. Your election must
be filed with the IRS by April 15 of the year in which you want to
switch to the MMA method. In other words, if you didn't file this
election last April, you won't be permitted to use the
mark-to-market method for 2001. You could, however, file your
election before April 2002, which would then allow you to use
MMA for 2002. Once again, be sure to consult a tax professional
who can help you weigh the pros and cons of choosing
mark-to-market accounting, and ensure that you follow the
appropriate filing procedures.
Michael Sincere is the author of three books on investing and
trading.
The content provided herein is general in nature and is for informational
purposes only. It is not intended to be, and should not be construed as, (i) a
recommendation; (ii) legal or tax advice; or (iii) a legal opinion. Laws of a
particular state or laws that may be applicable to a particular situation may
impact the applicability, accuracy, or completeness of this information.
Federal and state laws and regulations are complex and are subject to
change. Always consult an attorney or tax professional regarding your
specific legal or tax situation.
Fidelity makes no warranties with regard to the information provided or
results obtained by its use. Fidelity disclaims any liability arising out of your
use of, or any tax position taken in reliance on, the information furnished
herein.
As with all investing decisions at Fidelity, customers should determine
whether their trading activity meets their investment objectives. Fidelity does
not encourage day trading for any of its customers. |
