The risks associated with day trading extend beyond the actual investment. Before the trade is placed consideration needs to be given to the tax implications.
Profits and losses for day traders can be taxed under the rules for an investor, trader, mark-to-market trader or dealer. There are pros and cons to each method.
Facts and circumstances prevail. Yet, the rules are not always clear.
Investor vs. Trader
The factors you need to consider when determining if you are a trader or investor, include:
- Holding period.
- Frequency of trades and dollar amount of those trades.
- Does the taxpayer pursue the activity as a livelihood?
- Time devoted to the activity.
On the surface this may sound straight forward, but as Endicott vs Commissioner, TC Memo 2013-199 shows, it is not.
Endicott used a strategy of selling covered calls. He did not trade every day and usually allowed the options to expire.
Most people would consider Endicott an active trader. He had 204 trades in 2006 and 303 trades in 2007. The court concluded this was not substantial trading. However, in 2008, Endicott made 1,543 trades, which the court said was substantial.
Endicott had purchases and sales of around $7 million in 2006; nearly $15 million in 2007; and about $16 million in 2008. The court agreed these were all substantial amounts. But the court couldn’t keep it simple. They went on to say “managing a large amount of money is not conclusive as to whether a petitioner’s trading activity amounted to a trade or business.” The court is saying large amounts of money being traded is not enough. This is why tax professionals say “facts and circumstances” so often.
You can use this chart to help you make a determination for your situation.
Remember, these rules apply to taxpayers who buy and sell securities or commodities only. These rules do not apply to cryptocurrencies. The IRS considers all crypto as property. The SEC clearly states wash sale rules only apply to securities. This means wash sale rules do not apply to crypto. Significant tax-loss harvesting is possible as a result.
Tax Implications for Investors, Day Traders, MTM Traders and Dealers
The chart at the end of this post provides a guide on how taxes apply to investors versus day traders. The advantage of being a trader is the deductibility of margin interest and other business related expenses on Schedule C. Both investors and traders still face the capital loss limits, but traders get the additional deductions of related expenses and margin interest. (Long-term capital gains are taxed preferentially. As a trader, all the LTCGs get the favorable treatment while expenses can be deducted against other income, usually taxed at ordinary rates.)
(The capital loss limit allows the taxpayer to deduct losses of up to $3,000 ($1,500 if married filing separately) against other income.)
To avoid the capital loss limits you can elect to be a mark-to-market trader. Wash sale rules also do not apply to to MTM traders.
Dealers are required to follow MTM rules. (Dealers have a place of business where they engage in the buying and selling of securities for customers. )
A trader can elect to use mark-to-market rules [IRC Sec. 475(f)]. Most tax software has an elections page where you can check a box and the election is automatically populated.
- All securities gains and losses are treated as ordinary income or loss.
- Securities held at the end of the tax year are deemed sold at FMV.
- Basis of securities deemed sold at year-end are adjusted accordingly.
The biggest advantage of making the MTM election is to avoid the wash sale rules and to sidestep the capital loss limitations.
The MTM election can be revoked, but you must wait at least 5 years before you can elect again. Since the mark-to-market election has limits, you need to consider the election carefully.
Other issues to consider if you are thinking of making the MTM election:
- The MTM election must be made on a timely filed original return, without consideration for extensions, for the taxable year immediately preceding the election year.
- You can attach the election to a timely filed extension.
- You also must attach Form 3115 (Change of Accounting Method) if you do not make the election in your first year as a trader (Rev. Proc. 2019-43).
Investors, traders and MTM traders do not pay SE tax and earnings cannot be used to fund IRA/SEP contributions. However, a dealer does pay SE tax and can use gains for IRA/SEP contributions.
As you can see, this isn’t the easiest area of tax code to navigate. I strongly recommend you consult with a competent and qualified tax professional when dealing with the trader/investor classification and before you make the MTM election.
May all your trades be profitable.
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