It’s tax season. And there are some particular IRS rules regarding taxes and trading. We’re not tax accountants, but we want you to make smart choices about your taxes just like you make smart choices about your trades. This article will help you ask your accountant the right questions to make the process easier.
Are you an INVESTOR or a TRADER in the eyes of the IRS?
This is an important distinction because of how losses and other expenses can be deducted from your ordinary income. Typically, investors are limited to the losses they can take in a year and can’t deduct trading expenses. Traders have fewer limits on deducting losses and trading expenses. But the IRS considers you a trader according to strict rules. Just calling yourself a trader or being “active” isn’t enough. IRS Topic 429, https://www.irs.gov/taxtopics/tc429.html covers Investor or Traders status.
o Investor - IRS Definition:
- Buys & sells securities (including options) expecting income
- Trades for personal investment and not conducting a business
- Holds these securities for a substantial period of time
o Trader (“Business”) – IRS Definition:
- You must meet ALL of the following to qualify as a trader
- Seek profit from daily market movements and NOT from dividends, interest, or capital appreciation
- Activity must be “substantial”
- Activity must be carried on with continuity & regularity
- Furthermore, you should consider:
o Holding period of your positions
o Frequency & dollar amount of your trades
o Expectation of making a living off of your trading
o Amount of time you spend trading
So, just because you’re a tastytrader, selling options and spreads and buying them back on a regular basis, the IRS doesn’t necessarily consider you a trader for tax purposes. The IRS says, “If the nature of your trading activities does not qualify as a business, you are considered an investor and not a trader. It does not matter whether you call yourself a trader or a day trader, you are an investor.”
The real question is, then, does your trading qualify as a business? Unfortunately, the IRS doesn’t give you any parameters to make that decision. There are no set dollar amounts. No minimum number of trades. But from our experience, here are some thoughts to guide you:
- Holding period of your trades – If you are trading options the tastytrade way, your holding periods are most likely less than 60 days. Those are considered short–term. That would help classify you as a trader, but don’t rely on the holding criteria alone.
- Frequency & dollar amount of your trades – This matters a lot. Someone making a few trades per month is probably going to be considered an investor by the IRS. So you would need to probably be doing several more than a few trades per day to be considered a trader.
- Intention & expectation of making a living from trading – Be able to demonstrate that you’ve set up a business. For example, you’ve invested in technology, computer equipment or faster connectivity or Internet capacity to operate a daily trading business. In addition, you should be making your own trading decisions and not relying on advisors or money managers.
- Amount of time you spend trading – Are you spending more than half of your day trading or do you have another job? If this is something you are doing occasionally or on your lunch break or in between unrelated meetings, you’re probably not going to qualify as a trader.
If you think you might qualify for trading status, here are some of the reporting requirements around calling it a business.
- Form 1040, Schedule C = Profit or Loss From Business
This is where a trader would record trading expenses instead of a Schedule A used by an investor. You may also decide to create an entity like an S-Corporation Form 1120S, for example, and report expenses differently. However, keep in mind that creating a separate company can also be an added expense and maintenance that if you are not a true business for the long-term may just be an added expense. An S-Corp isn’t for everybody.
- Traders can elect mark-to-market treatment, but investors can’t. A 475(f) election is when you choose to mark-to-market open positions at the end of the calendar year.
- WITHOUT a 475(f) election, you file Form 1040, Schedule D & Form 8949. You must treat trading gains & losses as capital gains & losses and the capital loss limitations and wash sales still apply. So, if you don’t make the election, it appears the only benefit of being a trader is that you basically get to take your other business expenses on Schedule C in “full” instead of being limited on Schedule A.
- WITH a timely 475(f) election, you file Form 1040, Schedule D & Form 4797. You can treat the trading gains & losses as ordinary income, and capital loss limitations and wash sales do NOT apply. But use caution, because if you trade 1256 contracts (futures, options on futures & broad based index options, for example) and if you don’t separate those as investments, you will lose the advantageous 60/40 tax rates that apply for investors on those products, because it will all be considered ordinary income.
If you don’t qualify as a trader, these are the reporting requirements.
o Investor Forms & Items to Note:
- Form 1040, Schedule D = Capital Gains & Losses
- Form 8949 = Sales & Other Dispositions of Capital Assets
- Form 1040, Schedule A = Itemized Deductions (which would include expenses like advice, legal, accounting, investment newsletters, etc. & may be limited under your itemized deductions)
- Capital loss limitations apply
- Wash sales apply
The bottom line is that it’s not easy to be considered a trader in the eyes of the IRS. Even if you are, there are benefits and pitfalls. Discuss these with your tax professional. But hey, no matter what the IRS calls you or how you’re taxed, you’ll always be a tastytrader!
Read more about trader tax questions here and watch our shows on tastytrade.com. Stay tasty, my friends!