Trader Status Analysis :: Day Trading Accountant Services

Trader Status Analysis

Trader vs. Investor
If you are an active trader, there is a chance you may qualify for a preferred filing status with the IRS. When you file your taxes, the default filing status is that of an "investor". But if you spend your days buying and selling stocks like a hedge fund manager, then you could qualify for "trader status" and could save a substantial amount of money at tax time. How? Because "trader status" allows you to fully deduct all your investing expenses, such as newsletter subscriptions, your home office, and your computer equipment.

So what are you, you ask, a trader or an investor? We wish we could give you the answer. Duane Severson, one of our resident tax experts and an Enrolled Agent (special designation given by IRS), has over 20 years of experience auditing individuals, corporations, and partnerships for the IRS. He revealed his insight into the workings of the IRS when he commented on the ambiguity of the trader status situation. He said, "It is not in the IRS's best interest to clarify the law." Says Don Roberts, an IRS spokesman, "The question is clear; the answer is not." The only way to define your status is to follow the guidelines developed through recent court cases addressing the matter.

The courts say you are a trader if the following items are met:

The trading is “substantial”. That means the trader has to buy and sell securities frequently to catch the daily movements in the market with the intent to profit on the short-term basis. The term “frequent” is not defined, but it is assumed that a trader would be trading with a number of transactions each day.
The trader spends a large amount of time in trading activities, and is not a casual investor.
The trader manages his own transactions.
Profits are geared toward the short-term rather than the long-term. The holding period for securities is a critical item that the courts have looked at. If securities are held for months rather than days, it is assumed the person is an investor, looking to profit from stock appreciation or dividends, and not the short-term gain.
Does the person have another full time job? If so, does it have any relationship to the trading activities? Where does the trader spend the majority of his time? What is the trader's intent? Does the trader plan on earning his living by trading?
If the person has a full-time job it will be more difficult to qualify as a trader, so these qualifications need to be evaluated much closer.
Even though a trader may have many transactions (500 or more), they still may be an investor if the holding period is a matter of months rather than days or weeks.
What is the person doing to learn the strategies? Financial seminars? Books and materials?
You spend lots of time trading. Preferably, you do not have a regular full-time job. (It is possible to be a part-time trader, but you had better be buying and selling a handful of stocks just about every day.)
You have established a regular and continuous pattern of making numerous trades (several and almost every day the markets are open).
Your goal is to profit from short-term market swings rather than from long-term gains or dividend income.

Trader Benefits
If you think you can qualify as a trader, here’s your reward. According to the tax law, traders are in the business of buying and selling securities. From the IRS’s perspective, you are self-employed, meaning you can deduct all your investing expenses on Schedule C like any other sole proprietor. This is great, because investors have to account for these expenses on Schedule A, where they can write off only the amount that exceeds 2% of their adjusted gross income. Plus, Schedule C write-offs reduce your adjusted gross income, which raise the odds that you can fully deduct all your personal exemptions and other tax goodies.

You can also deduct your margin account interest on Schedule C and probably take an immediate write-off of up to $19,000 a year for equipment used in your trading activities more than 50% of the time (computer stuff, desk, bookshelves, fax machine, etc.; it’s called a Section 179 write-off). Home-office deduction? Sure, as long as you use the space regularly and exclusively for trading, and the deduction does not throw you into a net loss position. Finally, you do not have to pay self-employment tax on your net profit, because capital gains are exempted. All in all, a pretty good deal.

If you’re a trader, you will still report gains and losses on Schedule D, and can still deduct only $3,000 in net capital losses each year. All this makes for a pretty funky-looking tax return. Schedule C will have nothing but expenses and no income, while your trading profits (we hope) will end up on Schedule D. We recommend attaching a statement to your tax return explaining your situation.

Mark-to-Market Traders
If you qualify as a trader, the IRS has a deal for you. Under normal circumstances, when you sell a stock at a loss, you get to write off that amount. But if you buy the same stock within 30 days, before or after you sell, the IRS considers it a "wash sale" -- and you may never be able to take the write-off. Fortunately, you can become what’s called a "mark-to-market" trader, meaning that you will automatically become exempt from the wash-sale rule (which can be a killer for serious traders) all year long.

Here’s how the mark-to-market rules work. On the last trading day of the year, you pretend to sell all your holdings. Even though you still really hold the stocks, you book all the imaginary gains and losses as of that day for tax purposes. You then begin the new year with no unrealized gains or losses, as if you had bought back all the shares you had pretended to sell.

Being a mark-to-market trader has another advantage. Normally, investors can deduct only $3,000 in capital losses in a given year. But mark-to-market traders can deduct an unlimited amount of losses, which is a plus in a really awful market. The downside to being a mark-to-market trader is that you will never have any long-term capital gains, but being a trader you should not have any anyway. For more information, see IRS Revenue Procedure 99-17 in Internal Revenue Bulletin 99-7, which is available at the IRS Web site.