Trader tax status in the United States is an IRS designation for people who either make a living by trading securities or who do a substantial amount of trading with the intent of making a profit. This status has a number of tax benefits that are not available to investors or to traders who are casual traders or not in the business of trading.
Trader Tax Status Allows Mark-To-Market Accounting
A securities trader who qualifies for trader tax status may elect to use mark-to-market accounting. This is a procedure followed at year end, when any securities held into the next tax years are marked to then-current market value, and any profit or loss is taken in that tax year. Many of the benefits related to trader tax status come from the trader electing to use mark-to-market accounting.
- All gains are treated as ordinary gains, not capital gains. This will be the case anyway for most traders, since all of a trader’s income/losses are from short-term positions.
- Trading losses can be deducted without limit. The investor cannot deduct more than $3,000 of uncovered losses in a year.
- “Wash sale” loss-deferral rules (explained below) do not apply to those who qualify for trader tax status.
- Net operating loss carry-back is applicable.
Some of these benefits are discussed herein.
The trader use of mark-to-market accounting is a completely different situation than the mark-to-market accounting used by banks and other financial institutions that helped to spark the 2008 financial crisis in the US.
Trader Tax Status Gives the Ability to Deduct All Losses
An investor in securities cannot deduct all losses related to those investments. The limit on deducting losses that exceed gains in any given year is $3,000. This also applies to someone with trader tax status who uses the cash accounting basis. Losses in any year that exceed $3,000 must be carried forward and offset gains in future tax years.
If an investor or cash-basis accounting trader had a bad year and lost, say, $30,000, the maximum deduction allowed is $3,000. The $27,000 can be carried forward into future tax years, offsetting income in those years, always limited to $3000 in those years.
However, a trader who qualifies for trader tax status and who elects to do so can deduct all the losses in the year they occur. This means that other income, say from a full time or part time job, can be offset by trading losses. Of course, the trader hopes to make a profit, not incur losses. But when those losses happen, the ability to deduct them fully from taxes is an advantage over what investors can do.
Avoid “Wash Sale” Rules with Trader Tax Status
When a trader uses mart-to-market accounting, it is not necessary to follow the IRS’s “wash sale” loss deferral rules. A wash sale occurs when the same security is traded within a thirty day period. The IRS will not allow a loss to be claimed. This is to prevent the stock owner from selling stock at a loss to claim the loss on taxes and then buy it back immediately to retain ownership.
This rule is detrimental to traders, who often buy and sell the same security frequently, becoming an expert in the particular stock’s movements. The record keeping rules for wash sales are particularly burdensome on traders. However, with trader tax status and mark to market accounting, wash sale rules don’t apply. The profit or loss on a given trade stands alone, even if the security is sold many times within thirty days, even multiple times in a single day.
Treating Trading as a Business or Profession
When claiming trader tax status, a trader is stating they are trading for a business, intending to make a profit at it and establish a significant portion of their finances from it. As with all businesses, all expenses related to profit making activities are deductible. This includes:
- Investment interest, when securities are traded on margin
- Home office expense
- Internet expense
- Trading software expense
- Stock or securities data required for trading decisions
- Brokerage account fees
- Depreciation on computers, printers, and office furniture and equipment
These expenses are reported by the trader on Schedule C, Profit or Loss From Business.
Most of these deductions are not available to investors when they exceed profits for the year. Some expenses can be carried over to a later year and potentially offset future profits, but generally the greatest benefit comes from being able to deduct all expenses in the year they occur. Accounting is also simpler for this, and losing track of some deductible expense is less likely.
For the trader who qualifies, trader tax status is a great advantage, and will generally result in lower taxes.
References:
The Tax Guide For Traders, by Robert A. Green, CPA, McGraw Hill, 2004
IRS Publication 550, “Investment Income and Expenses”, 2009 tax year [See page 73]
David A. Todd - David Todd is a civil engineer, a genealogist, a citizen concerned with the environment, and a writer by passion.
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