Commodities and futures

Of the many reasons that day traders work with commodity and futures contacts, one is that the taxes are easy to handle. Under Section 1256 of the IRS code, certain types of contracts — for example, regulated futures contracts, foreign currency contracts, and non-equity options (on debt, commodities, currencies, and stock market indexes) that are marked-to-market in trading — are handled under the 60/40 rule. This rule stipulates that 60 percent of your total capital gain or loss will be treated as a long-term capital gain or loss, and the other 40 percent of your gain or loss will be treated as a short-term gain or loss. How long you held the position doesn’t matter. Why is this rule so nice? Because the long-term capital gains rate is less than the short-term rate, and you as a day trader can take advantage of it, even though, by definition, day traders don’t hold positions over the long haul.

Currency trading

If you trade currencies, the tax laws that apply to you can be confusing, and they have gray areas. The following can impact how taxes apply to you:

• Whether you’re an individual or a business: Small individual currency transactions are usually considered to be like-kind exchanges; for example, if you go on vacation to Mexico, exchange your dollars to pesos when the dollar is strong, and then change whatever remains back at the border a week later when the dollar is a bit weaker, you’ll have made a profit. However, this transaction is not a reportable one, because, in essence, you exchanged two identical items: money for money.

  A business, however, can accrue taxable gains and losses due to changes in exchange rates. If a company makes goods in the United States and sells them through its Mexican subsidiary, for example, the amount of profit or loss that the subsidiary has depends on the exchange rate between the dollar and the peso, and that determines the amount of tax that the company pays. In this case, identical objects aren’t being exchanged. (The IRS has plenty of rules on how businesses should handle foreign exchange under Section 988 of the tax code.)

• Whether you’re trading actual currency or futures and options on currencies: Futures and options on currencies are taxed under Section 1256 using the handy 60/40 rule described in the preceding section. But you’re trading in the spot market. You aren’t trading currency contracts; you’re trading actual currency. What do you do about profits and losses you may accrue?

  The IRS isn’t keen on your claiming a tax-free like-kind exchange if your goal is to make a living trading currencies. But you aren’t running a business with overseas operations, are you? Unfortunately, there are no clear guidelines here, so you probably want to work with an accountant. The general thought is that you can report your currency trading through Section 988 or Section 1256. Under Section 988, your trading gains and losses are considered short-term capital gains in your trading business. This arrangement saves you money if you lost money trading but costs you if you made money. Under Section 1256, your spot trading is handled as futures contracts, and you pay short-term capital gains taxes on 40 percent of your profits and long-term capital gains taxes on the remaining 60 percent of your profit. This saves you money in the years you made money.

  The key? Be consistent. You can’t file under Section 988 when you lose money and under Section 1256 in years you make money. That game makes the IRS very unhappy, and you don’t want to have the tax guys unhappy with you.

Although you should consider this entire chapter as a guideline and not professional tax advice, this warning holds particularly true for the information on currencies. At the time I am writing this, both the Commodity Futures Trading Commission and the Internal Revenue Service are taking a close look at the forex market to clarify the regulations, so the information may be very different when you do your taxes.

Options

The taxation of options is more complicated than the taxation of other derivatives. The basic information is the same: A gain on an option held for less than a year is a short-term capital gain, and a gain on one held for more than a year is a long-term capital gain. There are two problems, though. The first is that some options strategies offer a combination of short-term and long-term gains and losses. The second is that options trades fall under the wash-sale rule (explained later in this chapter), which limits your ability to make trades of fewer than 30 days in the same securities.

Options have one other wrinkle: You can’t use options to manage taxable sales and gains in stocks. An option on a stock is considered to be substantially identical to the stock. That’s why the tax treatment is pretty much the same — and why professional tax advice is really important if you’re trading options.

The Chicago Board Options Exchange publishes a detailed guide to stock and stock-options taxation. You can download it at www.cboe.com/LearnCenter/pdf/TaxesandInvesting.pdf.

Stock trading

In Chapter 2, I cover the differences between investing, trading, and gambling. Day traders aren’t investing; they’re looking to take advantage of short-term price movements, not to take a stake in a business for the long term. Unless, of course, you’re asking the IRS about it. The IRS defines trading much differently than people in financial circles do. To the taxmen, you are a trader only if all of the following apply to you:

• You seek to profit from daily market movements in the prices of securities, not from dividends, interest, or capital appreciation.
• Your activity is substantial; the IRS code does not spell out what substantial means, but it probably means you’re making at least 3,000 trades per year.
• You carry on the activity with continuity and regularity. In other words, day trading is more or less your full-time job, you’ve stuck with it for at least six months already, and you plan to keep trading into the next year.

The 2013 Tax Court case Endicott v. Commissioner addressed the issue of substantial when deciding whether a person is a trader. The plaintiff made 1,543 trades in 2008, which the IRS said was substantial. The 303 trades made in 2007 did not meet the definition. The taxpayer traded on 75 days in 2006, 99 days in 2007, and 112 days in 2008, and the court ruled that none of those met the requirement for frequent, continuous, or regular trading. This ruling is the clearest guidance issued in a long time.

IRS Tax Topic 429 covers the matter in more detail. If you trade part-time, have other employment, or are new to the day trading game, the IRS probably won’t let you define yourself as a trader. Don’t care what an IRS agent calls you, as long she doesn’t call you for an audit? Well, understanding the difference between trader and investor in IRS lingo is important to avoid that audit.

If you qualify as a trader, you enjoy deductions that regular investors don’t. You may quality as a trader for some of your activities and as an investor for others. If you think this scenario applies to you, you need to keep detailed records to separate your trades, and you should use different brokerage accounts to make the difference clear from the day you open the position.

In political economics, taxation serves two purposes. The first is to raise money for the government. The second is to encourage people to do things that the elected officials who amend the tax code want them to do. Much of the investing tax code is intended to promote the formation and growth of businesses. Short-term day trading doesn’t do that, so the tax law doesn’t offer short-term investors the same benefits that it gives to long-term investors and business owners.

The many flavors of tax experts

Okay, you’re waiting for me to say there’s only one flavor of accountant, and it’s plain vanilla, right? Wrong. Tax experts fall into several different categories, and knowing which is which can help you determine who is best for you:

• Certified public accountants: Certified public accountants studied accounting in college and passed exams testing their knowledge of a wide range of accounting subjects. Because much of accounting involves income-tax preparation, many CPAs specialize in this. CPAs generally have the best combined knowledge of tax laws and tax preparation techniques, but not all of them specialize in or even understand day trading.
• Enrolled agents: Enrolled agents specialize in tax preparation. They receive registration from the IRS after passing a two-day, eight-hour exam covering only tax topics, which is what they know best. They may not be so good at helping you with other accounting needs, such as preparing payroll for your office assistants.
• Tax attorneys: Tax attorneys usually work with CPAs; they are called in to study the legality of proposed strategies or represent a client in tax litigation. They aren’t appropriate for most traders, but you may have situations that call for one.
• Storefronts and volunteers (probably not a good idea): Every winter, vacant buildings are turned into tax-preparation centers, and the IRS promotes its cadre of volunteers who help people with their taxes. These services can be a boon to the average person who lacks the time or patience to deal with the tax forms. But if you are trader, you’re going to run into complex problems that most of these services are not prepared to handle, such as the many considerations that go with taxes on currency trading discussed previously.

Only CPAs, enrolled agents, and tax attorneys are allowed to represent clients before the IRS in audits, collections, or appeals. Other paid preparers can represent clients in an audit, but they can’t handle more complex matters.

Questions to ask a prospective adviser

After you identify a few prospective candidates to prepare your taxes, talk to them and ask them questions about their experience. You want someone who understands things such as the wash-sale rule (which can limit the deductibility of your losses and is covered in more detail in the later section “Understanding the wash-sale rule”) and the mark-to-market election (which can allow you to deduct more losses; see the section “Mark-to-market accounting”) and who can help you determine what you owe in taxes and not one penny more.

Here some things you should ask a potential tax preparer:

• What investors and traders have you worked with? For how long?
• Have you worked with traders or investors in my state? Can you prepare my state return?
• Have you helped traders make the mark-to-market election?
• What is your experience with the wash-sale rule? How will my trading style be affected by it?
• Who will be preparing my return? How involved will you be?
• Do you offer tax analysis of trading strategies?
• What’s your audit record? Why have your clients been audited? What happened on the audit?
• What are your fees?

By law, tax preparers cannot base their fees on the size of your tax refund, and they cannot guarantee you a refund. Any preparer who does these things either does not know the law or is willfully breaking it.

You’ll feel more comfortable with your tax preparer if you have an understanding of the issues at stake. Even if you are hiring someone — and you should — keep reading this chapter and check the appendix for references on taxes and trading.

Finding out everything you want to know

The IRS website, www.irs.gov, is a treasure trove of tax information. All the regulations, publications, forms, and explanations are there, and some of it is even in plain English. The site is so vast and detailed that you’ll probably be overwhelmed (I’m not sure there is any page in any IRS publication that doesn’t mention dividends received under the State of Alaska Permanent Fund).

Curious to know about this State of Alaska Permanent Fund? It’s an annual payment made to all residents of Alaska every year, based on the profits of oil pumped in that state. To put this amount into context, Alaska had 739,795 residents in 2017, according to the U.S. Census Bureau. I think there are two pages of IRS publications mentioning the fund for every person who gets a check from it.

The primary publication that covers the tax implications of trading and other investing activities is Publication 550, Investment Income and Expenses. It’s available at www.irs.gov/publications/p550/.

Making it easier with tax-preparation software

The brave people who do their own taxes know that tax-prep software is a godsend, and it’s even more valuable for those do-it-yourselfers who trade a lot. The software fills out the forms, automatically adds and subtracts, and even catches typographical errors. In many cases, it can download data straight from your brokerage account, making data entry really simple.

Most of the big brands, such as TaxCut and TurboTax, publish several editions each year — not all of which are set up to import and manage lots of trading data. Among those that have services for investors are TurboTax Premier Investments (www.turbotax.com), H&R Block at Home Premium (www.hrblock.com), and CompleteTax (www.completetax.com).

Earned income

Earned income includes wages, salaries, bonuses, and tips. It’s money that you make on the job. But even if day trading is your only occupation, your earnings aren’t considered to be earned income. Therefore day traders, whether classified for tax purposes as investors or traders, don’t have to pay the self-employment tax on their trading income. Isn’t that great?

Well, maybe, maybe not. The self-employment tax, the bane of many an independent business person, is a contribution to the Social Security fund. (Employees pay half of the contribution, and the employer pays the other half. The self-employed have to pay the whole thing.)

The problem is that if you don’t have earned income, you are not paying into Social Security. If you are not paying into Social Security, you may not be eligible for retirement benefits. To collect benefits, you have to have paid in 40 credits, and you can earn a maximum of four credits per year. Most employees do this easily, but if you’ve taken time off work or have a long history of work as an independent investor, you may not have paid enough in.

Any Social Security benefits you do collect are based on the 35 years of highest earned income over your work history. Your years of independent trading show up as years with zero earned income, which may hurt your ultimate benefit.

The Social Security Administration has a handy online calculator, www.socialsecurity.gov/planners/calculators.htm, which can help you determine whether day trading makes sense for you right now, given the possible effect on your Social Security benefits.

Investment income

Investment income is your total income from property held for investment before any deductions. It includes interest, dividends, annuities, and royalties. Investment income does not include net capital gains, unless you choose to include them. Do you want to include them? Well, read the next section.

Other than net capital gains, which you may or may not decide to include, most day traders have very little investment income for tax purposes.

Capital gains and losses

A capital gain is the profit you make when you buy low and sell high — the aim of day trading. The opposite of a capital gain is a capital loss, which happens when you sell an asset for less than you paid for it. Investors can offset some of their capital gains with some of their capital losses to reduce their tax burden.

Frequent traders have many capital gains and losses, though, and they may very well run afoul of complicated IRS rules about capital gains taxation. Capital gain and loss problems trip up day traders all the time. When designing your trading strategy, think long and hard about how much pain taxes may cause. The financial world is filled with horror stories of people who thought they found a clever angle on making big profits, only to discover at tax time that their tax liability was greater than their profit. In the real world, taxes matter.

Capital gains come in two flavors: short term and long term. You’re charged a low rate (the current rate is 15 percent) on long-term capital gains, which right now is defined as the gain on assets held for more than one year. Short-term capital gains, which are those made on any asset held for one year or less, are taxed at the ordinary income rate, probably 28 percent or more.

Miscellaneous income

Miscellaneous income is money that you received that wasn’t earning income, investment income, or capital gains. This kind of income is often payment received in the course of a business or trade. As a freelancer, most of my income is reported to the IRS in the miscellaneous category. Anyone who pays me for my services has to send me Form 1099-Misc at the end of the year, with a copy going to the IRS, to help the agency track my earnings. Some proprietary traders that provide services for day traders (covered in Chapter 11) report your profits and losses on Form1099-MISC. Miscellaneous income is handled as self-employment income and must be reported.

Qualified and deductible expenses

You can deduct investment expenses as miscellaneous itemized deductions on Schedule A of Form 1040 as long as these expenses are ordinary, necessary, directly related to the taxable income produced, and used to produce or collect income or manage property held for producing income. By the way, writing off these expenses only makes sense if you have more than $12,000 in expenses as an individual or $24,000 as a married couple.

What you can’t deduct

As you day trade, you’ll probably incur expenses that can’t be deducted from your taxes. Disappointing, I know, but if you know what these nondeductible expenses are upfront, you can plan accordingly.

Recognizing the limitations

You didn’t think the IRS would let you take all your deductions automatically, did you? Of course not. Your deductions may be limited, especially if you don’t meet the IRS definition of trader.

Mark-to-market accounting

Under mark-to-market accounting, you no longer have to track capital gains. Instead, you pretend to sell your portfolio at the end of the year and then pretend to repurchase everything at the beginning of the new year so that all capital gains fall into income.

Because day traders usually close all their positions at the end of the day anyway, mark-to-market accounting may not seem like a big deal, but it is: In effect, converting all capital gains to income means that your trades are no longer subject to the wash-sale rule. For most day traders, this lowers taxes and results in fewer paperwork hassles.

If you use mark-to-market accounting, you can no longer get the 15 percent rate on any long-term capital gains from your trading activities. Unless you work with listed options on market indexes, which are considered to show profits that are 60 percent long-term capital gains and 40 percent short-term capital gains, you may not have any long-term capital gains from your trading activities.

Greater deductibility of business expenses

In general, the IRS allows investors to deduct business expenses only if these expenses exceed the $12,000 single/$24,000 married standard deduction. However, anyone who gets to join the charmed circle of IRS-qualified traders gets to deduct 100 percent of expenses, regardless of their adjusted gross income. They get to deduct all their investment interest, too.

One caveat, though: The IRS assumes that people are in the business of trading because they are making money at it. If you lose money for three out of five years, even if it’s because your expenses exceeded your investment profits rather than due to trading losses, the IRS will probably kick you out of the club.

Using the right tax forms

Many of the differences in income and expenses discussed already in this chapter make more sense when you think about how they are reported on your income tax return. In this section, I give you the highlights of some of the most exciting forms for the modern day trader. Note that they are different for those who qualify as traders by IRS standards (refer to the earlier section “Stock trading”) than for everyone else who day trades.

• Forms for qualified traders: If you make the mark-to-market election on Form 3115 (refer to the section “Mark-to-market accounting”), you’re considered to be in the business of trading. Business expenses for individual tax filers are put on Schedule C of Form 1040, Profit or Loss from Business. Then your trading gains and losses are recorded on Part II of Form 4797. If you have any securities at the end of the year in your trading account, pretend that they were sold on the last business day of the year at current fair market value and then immediately reacquired.
• Forms for everyone else: Day traders who are not considered traders by the IRS should itemize business deductions and investment interest expenses on Schedule A of Form 1040. You should attach Form 4952 if you used it to figure your investment interest expense. You report capital gains and losses from your trading on Schedule D of Form 1040, subject to all the limits on losses.

Paying all year: The joy of estimated taxes

If you have been an employee for years and years, all your tax liabilities may have been covered by your payroll tax deductions. The IRS likes it best that way, because then it gets money all year round. Face it: the easier it is to pay, the more likely you are to do it.

People who are self-employed or who have significant earnings from investments and day trading may generate more income than can be covered from payroll withholding. What you need to do is estimate your tax liability four times a year and then write a check for those amounts. (Otherwise, you could face a penalty at tax time.) Estimated taxes are paid on Form 1040 ES and are due April 15, June 15, September 15, and January 15.