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THE TAX GUIDE FOR TRADERS
By Robert Green The McGraw-Hill Companies, Inc.
Copyright © 2005The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-145463-6
Excerpt
CHAPTER 1
Are You a Business Trader?
Active traders who rise to the level of "trading as a business" (as a sole proprietor or in an entity) qualify (in the eyes of the IRS) for trader tax status. These traders have two principal tax benefits over investors. The first is that traders may consider their trading losses (if mark-to-market) and business expenses as "ordinary" deductions from gross income, and they can be deducted without any kind of limitations. Investors are severely limited under the tax code from deducting their trading losses and expenses. They are subject to capital loss limitations, wash sale loss deferral rules, and limitations on deducting their investment interest expenses and investment expenses as itemized deductions. Investors have no tax benefits over traders, although both may benefit from long-term capital gains rate relief.
The first part of trader tax status, ordinary business expenses, is mandatory and always beneficial taxwise. It provides a lot of leeway. Trader tax status may be applied (claimed) to a trader's tax returns after the fact, which means that you may take this trader tax status benefit for all "open year" tax returns. Open years include the current tax year, the tax year just ended (for which you may or may not have filed a tax return already), and filing amended tax returns limited to the prior three tax years. In other words, you can read this book, determine whether you qualified for trader tax status, and then file amended tax returns to claim tax refunds for your trading business expenses.
The average trader saves significant taxes each year by using the first part of trader tax status: ordinary business expenses. The average trader is able to deduct computer hardware and software costs, home office expenses, margin interest expenses, Internet services, and other traditional trading expenses (such as research, books, periodicals, online subscription services, chat room services, seminars, travel to conventions, meals and entertainment with other traders, professional tax service and guide expenses, phone, furniture, fixtures, and more). Remember, investors may only deduct a fraction of these types of expenses, and the amounts they can deduct are severely limited, due to an itemized deduction phase-out, a 2 percent AGI miscellaneous expense floor, and no deduction for the alternative minimum tax calculation.
The second part of trader tax status is mark-to-market accounting. The details of mark-to-market will be discussed in Chapter 2.
HOW TO QUALIFY FOR TRADER TAX STATUS
Qualification: The First Step
Before you are able to use trader tax status benefits (i.e., business expenses and the opportunity to elect mark-to-market accounting), you first must qualify as a trader in the eyes of the IRS. Even if you don't choose mark-to-market accounting, gaining trader tax status is beneficial in all instances. It allows you to report your trading expenses on an individual tax return, Schedule C, and you may amend past tax returns after the fact (up to three years prior) if you qualify as a trader for those years. MTM accounting may not be taken after the fact.
The Tax Laws for Qualification
Unfortunately, no objective tests establish qualification. It is dependent on existing tax court cases, most of which happened well before the online trading revolution. The tax court developed a two-part test, and both parts must be satisfied for a trader to qualify for trader tax status. As you will see, however, both parts are ambiguous and leave plenty of room for interpretation:
1. The taxpayer's trading must be substantial, regular, frequent, and continuous. Sporadic trading won't be a trade or business.
2. The taxpayer seeks to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments.
Many traders need more help in determining whether they qualify. The following scenarios are situations our firm encountered over the years, but they are hypothetical and you are not automatically disqualified if you do not fit into one of the categories. Your best bet is to consult a trader tax professional.
If you are a full-time trader (and you have no other major sources of income to pay your living) and you spend all day, every day trading, you qualify without question (unless you lose money every year).
If you are a part-time trader because you have another business activity (a business or a job), the IRS will scrutinize your qualification for trader tax status, especially if you elect mark-to-market accounting and carry back a huge net operating loss (NOL), which will be described in detail later on in the book. You can still qualify as a part-time trader if you can prove to the IRS that you spend more than three hours per day in your trading business. If you trade less than once per day, the IRS may reject your trader tax status.
If you qualify as a pattern day trader (PDT) under the rules implemented by the Securities and Exchange Commission (SEC) in 2001 (i.e., you make more than four day trades in a five-day period), it is a big plus if you are being questioned by the IRS. However, if you are not a PDT, it does not automatically mean you will not qualify.
IRS PUBLICATION 550: SPECIAL RULES FOR TRADERS IN SECURITIES
What follows is an excerpt of the special rules for traders from IRS Publication 550. We add our observations in italics.
Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.
* You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
Observation: Most active securities traders easily meet this condition; their dividends received are a tiny fraction of their sales proceeds.
* Your activity must be substantial.
Observation: Most active traders easily meet this condition. They have one or more active online or direct-access brokerage accounts, they spend countless hours watching and reading business news, they buy trading books and online services, they buy computers and software just for their trading business, and they generate millions of dollars in sales proceeds from "churning" their own accounts.
* You must carry on the activity with continuity and regularity.
Observation: Most active traders easily meet this condition, although part-time traders may have a difficult time. Full-time traders are busy in the markets throughout every trading day. However, certain other traders are not able to trade every trading day or throughout the trading day—traders such as part-time traders who have other jobs or business activities.
The following facts and circumstances should be considered in determining if your activity is a securities trading business:
* Typical holding periods for securities bought and sold.
Observation: Most active traders easily meet this condition. They don't hold positions open for longer than a few weeks, and in the case they do, they usually are trading around that position as part of a hedge. Some traders hold positions for a day (day traders), others for a few days, and still others for a few weeks to a month (swing traders).
All of these types of traders may qualify. The longest holding periods are with swing traders. One site on the Internet describes swing trading as follows: "Taking advantage of brief price swings in stocks lasting
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Excerpted from THE TAX GUIDE FOR TRADERS by Robert Green. Copyright © 2005 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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