The tax law recognizes three types of individuals who may sell and buy securities. They are:
The tax rules applied to traders are a hybrid of tax rules applied to investors and business persons, as discussed in the following paragraphs.
Unless a trader previously made a mark-to-market election, gains and losses are reported as capital gains and losses on Form 8949 and Schedule D. As almost all or substantially all of a trader’s sales are short-term, such gains are reported as short-term gains and losses as short-term losses. A net profit from Schedule D is not subject to self-employment tax (45.1). Substantial losses subject to capital loss treatment are a tax disadvantage because capital losses in excess of capital gains are deductible only up to $3,000 of ordinary income in one tax year. True, carryover capital losses may offset capital gains in the next year, but your inability to deduct them immediately may subject you to paying a tax liability that might have been reduced or eliminated if the losses had been deductible for the year of the sale. If you are concerned about incurring substantial short-term capital losses that would be limited by capital loss treatment, you may consider a mark-to-market election (30.17), which would allow you to treat your security gains and losses as ordinary income and loss.
Although a trader does not sell to customers but for his or her own account, a trader is considered to be in business. Expenses such as subscriptions and margin interest may be deducted as ordinary business losses on Schedule C of Form 1040. Home office expenses are deductible if the office is regularly and exclusively used as the principal place of conducting the trading business (40.12); the deduction is computed on Form 8829 and entered on Schedule C.
An investor, on the other hand, may deduct margin interest only as an itemized deduction to the extent of net investment income (15.10). Other investment expenses are allowed only as miscellaneous itemized deductions and only to the extent that, when added to other miscellaneous costs such as fees for tax preparation, they exceed 2% of adjusted gross income (19.1). An investor may not deduct home office expenses since investment activities, no matter how extensive, are not considered a business; see the Moller decision discussed in 40.16.
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