Chapter 30
Tax Rules for Investors in Securities

You have the opportunity to control the taxable year in which to realize gains and losses. Gains and losses are realized when you sell, and if there are no market pressures, you can time sales to your advantage.

If you sell securities at a gain in 2017, and you held the securities more than one year, you can benefit from the 0%,15% or 20% rate for long-term capital gains.

The $3,000 limitation ($1,500 if married filing separately) on deducting capital losses from other types of income is a substantial restriction. If you have capital losses exceeding the $3,000 (or $1,500) limit, it is advisable to realize capital gains income that can be offset by the losses.

Investors who have multiple or numerous transactions throughout the year generally need not manually enter each transaction on self-prepared returns or provide details to a tax return preparer. Tax return preparation software allows transactions through brokerage firms and mutual fund companies to be imported to your tax return by a simple keystroke. The information contained in this chapter is intended to provide general information on the underlying tax implications of securities.

30.1 Planning Year-End Securities Transactions

First establish your current gain and loss position for the year. List gains and losses already realized from completed transactions. Then review the records of earlier years to find any carryover capital losses. Include nonbusiness bad debts as short-term capital losses. Then review your paper gains and losses and determine what losses might now be realized to offset realized gains or what gains might be realized to be offset by realized losses.

If you have already realized net capital losses exceeding $3,000 ($1,500 if married filing separately), you may want to realize capital gains that will be absorbed by the excess loss. Remember, only up to $3,000 (or $1,500) of capital losses exceeding net capital gain may be deducted from other income such as salary, interest, and dividends.

Planning for losses. Realizing losses may pose a problem if you believe the security is due to increase in value sometime in the near future. Although the wash sale rule (30.6) prevents you from taking the loss if you buy the security 30 days before or after the sale, the following possibilities are open to you.

• If you believe the security will go up, but not immediately, you can sell now, realize your loss, wait 31 days, and then recover your position by repurchasing before the expected rise.
• You can hedge by repurchasing similar securities immediately after the sale provided they are not substantially identical. They can be in the same industry and of the same quality without being considered substantially identical. Check with your broker to see if you can use a loss and still maintain your position. Some brokerage firms maintain recommended “switch” lists and suggest a practice of “doubling up”—that is, buying the stock of the same company and then 31 days later selling the original shares. Doubling up has disadvantages: It requires additional funds for the purchase of the second lot, exposes you to additional risks should the stock price fall, and the new shares take a new holding period.

30.2 Earmarking Stock Lots

Keep a record of all your stock transactions, especially when you buy the stock of one company at varying prices. By keeping a record of each stock lot, you may control the amount of gain or loss on a sale of a part of your holdings. If you do not make an adequate identification, the IRS will treat the shares you bought first as the shares being sold under a first-in, first-out (FIFO) rule.

You may not average the cost of stock lots; averaging is generally allowed only for mutual fund shares (32.10). However, under the basis reporting rules (5.8) for “covered” securities acquired after 2011, averaging is allowed for most ETFs structured as regulated investment companies, and for shares acquired through a qualifying dividend reinvestment plan (DRIP).

If your stock is held by your broker, the IRS considers that an adequate identification is made if you give instructions to your broker about which particular shares are to be sold, and you receive a written confirmation of your instructions from the broker or transfer agent within a reasonable time.

30.3 Sale of Stock Dividends

A sale of stock originally received as a dividend is treated as any other sale of stock. The holding period of a taxable stock dividend (4.8) begins on the date of distribution. The holding period of a tax-free stock dividend or stock received in a split (4.6) begins on the same date as the holding period of the original stock.

Basis of tax-free dividend in the same class of stock. Assume you receive a common stock dividend on common stock. You divide the original cost by the total number of old shares and new shares to find the new basis per share.

Basis of tax-free dividend in a different class of stock. Assume you receive preferred stock dividends on common stock. You divide the basis of the old shares over the two classes in the ratio of their values at the time the stock dividend was distributed.

Basis of taxable stock dividend. The basis of a taxable stock dividend (4.6) is its fair market value at the time of the distribution. Its holding period begins on the date of distribution. The basis of the old stock remains unchanged.

30.4 Stock Rights

The tax consequences of the receipt of stock rights are discussed at 4.6. The following is an explanation of how to treat the sale, exercise, or expiration of nontaxable stock rights. The basis of taxable rights is their fair market value at the time of distribution.

Expiration of nontaxable distributed stock rights. When you allow nontaxable rights to expire, you do not have a deductible loss; you have no basis in the rights.

Sale of nontaxable distributed stock rights. If you sell stock rights distributed on your stock, you treat the sale as the sale of a capital asset. The holding period begins from the date you acquired the original stock on which the rights were distributed.

Purchased rights. If you buy stock rights, your holding period starts the day after the date of the purchase. Your basis for the rights is the price paid; this basis is used in computing your capital gain or loss on the sale.

If you allow purchased rights to expire without sale or exercise, you realize a capital loss. The rights are treated as having been sold on the day of expiration. When purchased rights become worthless during the year prior to the year they lapse, you have a capital loss that is treated as having occurred on the last day of the year in which they became worthless.

Figuring the basis of nontaxable stock rights. Whether rights received by you as a stockholder have a basis depends on their fair market value when distributed. If the market value of rights is less than 15% of the market value of your old stock, the basis of your rights is zero, unless you elect to allocate the basis between the rights and your original stock. You make the election on your tax return for the year the rights are received by attaching to your return a statement that you are electing to divide basis. Keep a copy of the election and the return.

If the market value of the rights is 15% or more of the market value of your old stock, you must divide the basis of the stock between the old stock and the rights, according to their respective values on the date of distribution.

No basis adjustment is required for stock rights that become worthless during the year of issue.

30.5 Short Sales of Stock

A short sale is a sale of stock borrowed from a broker. The short sale is closed when you replace the borrowed stock by buying substantially identical stock and delivering it to the broker or by delivering stock that you held at the time of the short sale. One objective of a short sale is to profit from an anticipated drop in the market price of the stock; another objective may be to use the short sale as a hedge.

Tax rules applied to short sales are designed to prevent you from:

• Postponing gain to a later year when you sell short while holding an appreciated position in the same or substantially identical stock. This type of short sale is called “a sale against the box.”
• Converting short-term gains to long-term gains.
• Converting long-term losses to short-term losses.

Year in which gain on short sale is realized. Generally, you report gain on a short sale on Form 8949 and Schedule D for the year in which you close the short sale by delivering replacement stock. However, if you execute a short sale while holding an appreciated position in the same stock (short sale against the box) or substantially identical stock is acquired to close an appreciated short position, the short sale or acquisition of substantially identical stock is treated as a constructive sale of an appreciated financial position (30.9) and you must report the transaction in the year of the constructive sale, even though delivery of replacement stock is made in a later year; see Examples below.

There is this exception to the constructive sale rule: The short sale is reported in the year of delivery of the replacement stock if (1) you close the short sale before the end of the 30th day of the next year, (2) you continue to hold a similar position in the stock for at least 60 days after the closing of the short sale, and (3) your risk of loss during the 60-day period was not reduced by other positions. See Example 3 below and 30.9 for further details on constructive sales.

If the stock sold short becomes worthless before you close the short sale, you recognize taxable gain in the year the shares became worthless.

Short-term or long-term gain or loss. Whether you have short-term or long-term capital gain or loss generally depends on your holding period for the property delivered to the broker to close the short sale. Furthermore, you must apply Rules 1 and 2 below if you answer “yes” to either of the following questions:

* When you sold short, did you or your spouse hold for one year or less securities substantially identical to the securities sold short? (Substantially identical securities are described at 30.6.)

* After the short sale, did you or your spouse acquire substantially identical securities on or before the date of the closing of the short sale?

Rule 1. Gain realized on the closing of the short sale is short term. The gain is short term regardless of the period of time you have held the securities as of the closing date of the short sale.

Rule 2. The beginning date of the holding period of substantially identical stock is suspended. The holding period of substantially identical securities owned or bought under the facts of question (1) or (2) does not begin until the date of the closing of the short sale (or the date of the sale, gift, or other disposition of the securities, whichever date occurs first). But note that this rule applies only to the number of securities that do not exceed the quantity sold short.

Losses. A loss on a short sale is not deductible until shares closing the short sale are delivered to the broker. You may not realize a short-term loss on the closing of a short sale if you held substantially identical securities long term (that is, for more than a year) on the date of the short sale. The loss is long term even if the securities used to close the sale were held for one year or less. This rule prevents you from creating short-term losses when you held the covering stock long term. Loss deductions on short sales may be disallowed under the wash sale rules in 30.6.

Expenses of short sales. Before you buy stock to close out a short sale, you pay the broker for dividends paid on stock you have sold short. If you itemize deductions, you may treat your payment as investment interest (15.10), provided the short sale is held open at least 46 days, or more than a year in the case of extraordinary dividends. If the 46-day (or one-year) test is not met, the payment is generally not deductible and is added to basis; in counting the short-sale period, do not count any period during which you have an option to buy or are obligated to buy substantially identical securities, or are protected from the risk of loss from the short sale by a substantially similar position.

Under an exception to the 46-day test, if you receive compensation from the lender of the stock for the use of collateral and you report the compensation as ordinary income, your payment for dividends is deductible to the extent of the compensation; only the excess of your payment over the compensation is disallowed. This exception does not apply to payments with respect to extraordinary dividends.

An extraordinary dividend is generally a dividend that equals or exceeds the amount realized on the short sale by 10% for any common stock or by 5% for any preferred stock dividends. For purposes of this test, dividends on stock received within an 85-day period are aggregated; a one-year aggregation period applies if dividends exceed 20% of the adjusted basis in the stock.

30.6 Wash Sales

The objective of the wash sale rule is to disallow a loss deduction where you recover your market position in a security within a short period of time after the sale. Under the wash sale rule, which applies to investors and traders (but not dealers), your loss deduction is barred if within 30 days of the sale you buy substantially identical stock or securities, you buy a “call” option on such securities, or you sell a “put” option on the securities that is “deep-in-the-money”. The wash sale period is 61 days—running from 30 days before to 30 days after the date of sale. The end of a taxable year during this 61-day period does not affect the wash sale rule. The loss is still denied. If you sell at a loss and your spouse buys substantially identical stock within this period, the loss is also barred.

The disallowed loss is added to the basis of the replacement stock.

The wash sale rule does not apply to gains. It also does not apply to acquisitions by gift, inheritance, or tax-free exchange.

Buying replacement shares through IRA. The IRS has ruled that buying replacement shares in a traditional IRA or Roth IRA triggers the wash sale rule. Some commentators had suggested that the wash sale rule should not apply because the seller and the IRA, although “related,” are different entities for tax purposes. The IRS disagrees. Although the IRA is a separate tax-exempt trust, the seller of the loss shares is treated as acquiring the replacement shares through the IRA.

There is an additional penalty for using an IRA to acquire replacement shares. The increase to basis that would have applied if the replacement shares had been bought in a taxable account is lost. When the replacement is made in a taxable account, the basis increase preserves for future use the economic value of the disallowed loss by allowing gain to be reduced, or loss to be increased, on a later sale of the replacement shares. However, there is no basis increase for the shares held in the IRA and the wash sale loss is permanently disallowed, making this a worse result than if the replacement had been made in a taxable account.

Loss on the sale of part of a stock lot bought less than 30 days ago. If you buy stock and then, within 30 days, sell some of those shares, a loss on the sale is deductible; the wash sale disallowance rule does not apply.

Oral sale-repurchase agreement. The wash sale rule applies to an oral sale-repurchase agreement between business associates.

Defining “substantially identical.” What is substantially identical stock or securities? Buying and selling General Motors stock is dealing in an identical security. Selling General Motors and buying Fiat Chrysler stock is not dealing in substantially identical securities.

Bonds of the same obligor are substantially identical if they carry the same rate of interest; that they have different issue dates and interest payment dates will not remove them from the wash sale provisions. Different maturity dates will have no effect, unless the difference is economically significant. Where there is a long time span between the purchase date and the maturity date, a difference of several years between maturity dates may be considered insignificant. A difference of three years between maturity dates was held to be insignificant where the maturity dates of the bonds, measured from the time of purchase, were 45 and 48 years away. There was no significant difference where the maturity dates differed by less than one year, and the remaining life, measured from the time of purchase, was more than 15 years.

The wash sale rules do not apply if you buy bonds of the same company with substantially different interest rates, buy bonds of a different company, or buy substantially identical bonds outside of the wash sale period.

Warrants. A warrant falls within the wash sale rule if it is an option to buy substantially identical stock. Consequently, a loss on the sale of common stocks of a corporation is disallowed when warrants for the common stock of the same corporation are bought within the period 30 days before or after the sale. But if the timing is reversed—that is, you sell warrants at a loss and simultaneously buy common stock of the same corporation—the wash sale rules may or may not apply depending on whether the warrants are substantially identical to the purchased stock. This is determined by comparing the relative values of the stock and warrants. The wash sale rule will apply only if the relative values and price changes are so similar that the warrants become fully convertible securities.

Repurchasing fewer shares. If the number of shares of stock reacquired in a wash sale is less than the amount sold, only a proportionate part of the loss is disallowed.

Holding period of new stock. After a wash sale, the holding period of the new stock includes the holding period of the old lots. If you sold more than one old lot in wash sales, you add the holding periods of all the old lots to the holding period of the new lot. You do this even if your holding periods overlapped as you purchased another lot before you sold the first. You do not count the periods between the sale and purchase when you have no stock.

Losses on short sales. Losses incurred on short sales are subject to the wash sale rules. A loss on the closing of a short sale is denied if you sell the stock or enter into a second short sale within the period beginning 30 days before and ending 30 days after the closing of the short sale. Furthermore, you cannot deduct a loss on the closing of a short sale if within 30 days of the short sale you bought substantially identical stock.

30.7 Convertible Stocks and Bonds

You realize no gain or loss when you convert a bond into stock, or preferred stock into common stock of the same corporation, provided the conversion privilege was allowed by the bond or preferred stock certificate.

Holding period. Stock acquired through the conversion of bonds or preferred stock takes the same holding period as the securities exchanged. However, where the new stock is acquired partly for cash and partly by tax-free exchange, each new share of stock has a split holding period. The portion of each new share allocable to the ownership of the converted bonds (or preferred stock) includes the holding period of the bonds (or preferred stock). The portion of the new stock allocable to the cash purchase takes a holding period beginning with the day after acquisition of the stock.

Basis. Securities acquired through the conversion of bonds or preferred stock into common take the same basis as the securities exchanged. Where there is a partial cash payment, the basis of the portion of the stock attributable to the cash is the amount of cash paid; see Examples 1 and 2 below.

If you paid a premium for a convertible bond, you may not amortize the amount of the premium that is attributable to the conversion feature.

30.8 Stock Options

Stock options are contracts to buy or sell a fixed number of shares by a set date (called the expiration date). Stock options are purchased from public exchanges. If you are buying an option, you are a holder; if you are selling an option, you are a writer. Writers receive a cash premium from the holder. While there are numerous variations on how stock options can be used as investment strategies, the basic ones include the following.

Calls. Buying a call gives the holder the right to buy a specified number of shares of the underlying stock at a given exercise price on or before the option expiration date. Selling a call gives the seller, called the writer, the obligation to sell shares to the holder at the agreed upon price on or before the option expiration date. The holder pays a premium to the writer for the right to buy the shares. If the price of the stock rises above the agreed-upon price (the strike or exercise price), the holder exercises the buy option and acquires the shares. If not, the holder lets the options expire. The holder can sell the call prior to the expiration date.

Puts. Buying a put gives the holder the right, but not the obligation, to sell a specified number of shares of the underlying stock at the given exercise price on or before the option expiration date. Selling a put gives the seller, called the writer, the obligation to buy shares from the holder at the agreed upon price (the strike or exercise price). The writer receives a premium for this obligation. If the stock price rises above the strike price, the holder does not exercise the put option. The holder may sell the put option before the expiration date.

30.9 Sophisticated Financial Transactions

Some individuals may engage in certain complicated and risky financial transactions in the stock market. These activities are not for the average investor, and the tax treatment of these transactions can be complex. The following is a brief overview of some of these transactions and where you can find more information if necessary.

Arbitrage transactions. These are transactions in which an investor simultaneously buys and sells securities, currency, or commodities in different markets to benefit from differing prices for the same asset. Special holding period rules apply to short sales involved in identifying arbitrage transactions in convertible securities and stocks into which the securities are convertible (see Treasury regulations under Internal Revenue Code 1233).

Constructive sales of appreciated financial positions. You have made a constructive sale of an appreciated financial position if you:

1. Enter into a short sale of the same or substantially identical property (30.5),
2. Enter into an offsetting notional principal contract relating to the same or substantially identical property,
3. Enter into a futures or forward contract to deliver the same or substantially identical property, or
4. Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into any of the above transactions.

A contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security is not a constructive sale if it settles within one year of the date you enter into it.

If you are considered to have transacted a constructive sale, you must report as taxable income gain on the financial position as if the position was sold at its fair market value on the date of the constructive sale. The property held by you receives a new holding period starting on the date of the constructive sale and its basis is the fair market value at that date. Thus, under the constructive sale rule you are also treated as immediately repurchasing the position as of the date of the constructive sale.

Straddle losses. Commodities and stock options can be used to straddle positions that an investor holds to effectively hedge his or her bets against future price changes. Generally, under tax accounting rules, losses are used to match unrealized gains. Find more information in the instructions to Form 6781 and in IRS Publication 550.

Regulated futures contracts. These are contracts to buy or sell commodities or currency on a futures exchange (e.g., the Chicago Board of Trade). Gain or loss is reported annually under the marked-to-market accounting system. Find more information in the instructions to Form 6781 and in IRS Publication 550.

Conversion transactions. A conversion transaction is one involving two or more positions taken with regard to the same or similar property. The investor is in the economic position of a lender who expects to receive income while undertaking no significant risks other than those of a lender. Conversion transactions are reported on Form 6781. However, the ordinary income element from a conversion transaction is not reported as interest; it is treated as ordinary gain on Form 4797.

30.10 Investing in Tax-Exempts

Interest on state and local obligations is not subject to federal income tax. It is also exempt from the tax of the state in which the obligations are issued. In comparing the interest return of a tax-exempt with that of a taxable bond, you figure the taxable return that is equivalent to the tax-free yield of the tax-exempt. This amount depends on your marginal tax bracket(your top tax rate). For example, a tax-exempt municipal bond yielding 3% is the equivalent of a taxable yield of 4.167% subject to a marginal tax rate of 28%.

You can compare the value of tax-exempt interest to taxable interest for your tax bracket by using this formula:

The denominator of the above fraction is:

    0.85 if your marginal tax bracket is 15%

    0.75 if your marginal tax bracket is 25%

    0.72 if your marginal tax bracket is 28%

    0.67 if your marginal tax bracket is 33%

    0.65 if your marginal tax bracket is 35%

    0.604 if your marginal tax bracket is 39.6%

AMT and other restrictions. In buying state or local bonds, check the prospectus for the issue date and tax status of the bond. The tax law treats bonds issued after August 7, 1986, as follows:

1. “Public-purpose” bonds. These include bonds issued directly by state or local governments or their agencies to meet essential government functions, such as highway construction and school financing. These bonds are generally tax exempt.

2. “Qualified private activity” bonds. Interest on private activity bonds is taxable unless the bond is a qualified bond. Qualified bonds generally finance housing, student loans, or redevelopment, or they benefit tax-exempt organizations. Interest on qualified private activity bonds issued after August 7, 1986, although tax free for regular income tax purposes, is a tax preference item for purposes of computing alternative minimum tax (23.3) unless an exception applies. Because of the AMT, these private activity bonds may pay slightly higher interest than public-purpose bonds.

   Several types of bonds have been excluded from private activity bond treatment so the interest is not treated as an AMT preference item, including qualified Section 501(c) (3) bonds, Gulf Opportunity Zone bonds, Midwestern disaster area bonds, most New York Liberty bonds, and qualified mortgage bonds issued after July 30, 2008. In addition, any bonds issued in 2009 and 2010 that would otherwise be considered private activity bonds are not treated as private activity bonds, so the interest on the 2009/2010 bonds is not a tax preference item.

   Your broker can help you identify bonds subject to and exempt from AMT preference item treatment.

3. “Taxable” municipals. These are bonds issued for nonqualifying private purposes. They are subject to federal income tax, but may be exempt from state and local taxes in the states in which they are issued.

30.11 Ordinary Loss for Small Business Stock (Section 1244)

Shareholders of qualifying “small” corporations may claim within limits an ordinary loss, rather than a capital loss, on the sale or worthlessness of Section 1244 stock. An ordinary loss up to $50,000, or $100,000 on a joint return, may be claimed on Form 4797. On a joint return, the $100,000 limit applies even if only one spouse has a Section 1244 loss. Losses in excess of these limits are deductible as capital losses on Form 8949. Any gains on Section 1244 stock are reported as capital gain on Form 8949.

An ordinary loss may be claimed only by the original owner of the stock. If a partnership sells Section 1244 stock at a loss, an ordinary loss deduction may be claimed by individuals who were partners when the stock was issued. If a partnership distributes the Section 1244 stock to the partners, the partners may not claim an ordinary loss on their disposition of the stock.

If an S corporation sells Section 1244 stock at a loss, S corporation shareholders may not claim an ordinary loss deduction. The IRS with Tax Court approval limits shareholders’ deductions to capital losses, which are deductible only against capital gains plus $3,000 ($1,500 if married filing separately) (5.4).

To qualify as Section 1244 stock:

1. The corporation’s equity may not exceed $1,000,000 at the time the stock is issued, including amounts received for the stock to be issued. Thus, if the corporation already has $600,000 equity from stock previously issued, it may not designate more than $400,000 worth of additional stock as Section 1244 stock.

   If the $1,000,000 equity limit is exceeded, the corporation follows an IRS procedure for designating which shares qualify as Section 1244 stock.

   Preferred stock issued after July 18, 1984, may qualify for Section 1244 loss treatment, as well as common stock.

2. The stock must be issued for money or property (other than stock and securities).
3. The corporation for the five years preceding your loss must generally have derived more than half of its gross receipts from business operations and not from passive income such as rents, royalties, dividends, interest, annuities, or gains from the sales or exchanges of stock or securities. The five-year requirement is waived if the corporation’s deductions (other than for dividends received or net operating losses) exceed gross income. If the corporation has not been in existence for the five years before your loss, then generally the period for which the corporation has been in existence is examined for the gross receipts test.

30.12 Series EE Bonds

Series EE savings bonds give you an opportunity to defer tax; see below. EE bonds may only be purchased online from Treasury Direct at www.treasurydirect.gov. They must be held 12 months from the issue date before they can be redeemed. Bonds cashed in any time before five years are subject to a three-month interest penalty; see the Example below.

Series EE savings bonds with an issue date on or after May 1, 2005, earn a fixed rate of interest.The Treasury announces the fixed rate that will apply to new bonds every May 1 and November 1. Interest accrues monthly and is compounded semiannually. EE bonds issued from May 1997 through April 2005 continue to earn market-based interest rates set at 90% of the average five-year Treasury securities yields for the preceding six months; these rates change every May 1 and November 1. EE bonds issued before May 1997 earn various rates depending on the date of issue.

Deferring tax on savings bond interest. Unless you report the interest annually, Series EE bond interest is deferred (4.29) until the year you redeem the bond or it reaches final maturity. When you redeem the bond, the accumulated interest is taxable on your federal return but not taxable on your state and local income tax return. If in the year of redemption you use the proceeds to pay for higher education or vocational school costs, the accumulated interest may be tax free for federal tax purposes (33.4).

Interest accrual dates for Series EE savings bonds. For EE bonds issued after April 1997, interest accrues on the first day of every month. For EE bonds issued before May 1, 1997, interest generally accrues twice a year: on the first day of the issue month and first day of the sixth month after the issue month. For example, if you own an EE bond issued in August 1995, interest accrues every August 1 (month of issue) and every February 1 (six months after the August issue month). There is an exception for EE bonds issued from March 1993 through April 1995; these bonds accrue interest monthly (not just twice-a-year) to guarantee a 4% return.

When you cash a bond, you receive the value of the bond as of the last date that interest was added. If you cash a bond in between accrual months, you will not receive interest for the partial period. For example, if interest on a bond issued before May 1,1997, accrues in February and August, and you cash a bond in during July, you would earn interest only through February. By waiting until August 1 to cash the bond, you would earn another six months of interest.

Final maturity for savings bonds. Do not neglect the final maturity date for older bonds. After the final maturity date, no further interest will accrue. No E bonds are still accruing interest. The last issued E bonds, those from June 1980, reached final maturity after 30 years in June 2010 and thus they, as well as all older E bonds, have ceased earning interest.

EE bonds issued in 1980 (the first year available) reached final maturity in 2010, 30 years after issue, after which no further interest has accrued. All EE bonds have 30-year maturities, so EE bonds issued in 1987 stopped earning interest in 2017 after they earned interest for 30 years, and EE bonds issued in 1988 will stop earning interest after the month in 2018 that is 30 years after issue.

Series HH bonds. HH bonds obtained before September 1, 2004, in exchange for savings bonds or savings notes pay taxable interest every six months at a fixed rate. Currently, all HH bonds are paying 1.5% per year. Interest is paid until final maturity is reached 20 years after issue.

30.13 I Bonds

Treasury “I bonds” provide a return that rises and falls with inflation. I bonds may only be purchased online from TreasuryDirect at www.treasurydirect.gov. However, you can ask the IRS on Form 8888 to use your federal tax refund to buy I bonds, either by directly depositing the refund into your TreasuryDirect account if you have one, or to buy paper bonds if you do not have a TreasuryDirect account; see the Form 8888 instructions.

I bonds earn interest for 30 years. Interest is credited to a bond on the first day of every month and paid when the bond is redeemed.

I bonds are not redeemable within the first 12 months. You forfeit the last three months of interest if you redeem an I bond within the first five years, the same rule as for EE bonds (30.12).

Rates. Interest on an I bond is determined by two rates. One rate, set by the Treasury Department, remains constant for the life of the bond. The second rate is a variable inflation rate announced each May and November by the Treasury Department to reflect changes reported by the Bureau of Labor Statistics in the Consumer Price Index. If deflation sets in, the variable rate will be negative for a six-month period and the negative rate will reduce the fixed rate, but not below zero, so, even if the negative variable rate exceeds the fixed rate, the redemption value of the bond is not reduced.

Income tax reporting. Investors may defer paying federal income taxes on I bond interest, which is automatically reinvested and added to the principal. Deferral applies to the fixed rate interest as well as the variable inflation rate interest. You may defer federal tax on the interest until you redeem the bond or the bond reaches maturity in 30 years (4.29). You may report the interest each year as it accrues instead of deferring the interest. I bond interest is exempt from state and local income taxes.

If an I bond is redeemed to pay for college tuition or other college fees, all or part of the interest may be excludable from income under the rules discussed in 33.4.

30.14 Trader, Dealer, or Investor?

The tax law recognizes three types of individuals who may sell and buy securities. They are:

Investor. You are an investor if you buy and sell securities for long-term capital gains and to earn dividends and interest.

Trader. You may be a trader if you buy and sell securities to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation. Your buy and sell orders must be frequent, continuous, and substantial. There are at present no clearcut tests to determine the amount of sales volume that qualifies a person as a trader. The term “trader” is not defined in the Internal Revenue Code or Treasury regulations. The IRS has not issued rulings for determining trader status. The Tax Court has held that sporadic trading does not qualify; see the Examples below.

Dealer. You are a dealer if you hold an inventory of securities to sell to others. Dealers report their profits and losses as business income and losses under special tax rules not discussed in this book.

Tax treatment of traders. The tax rules applied to traders are a hybrid of tax rules applied to investors and business persons, as discussed in the following paragraphs.

Reporting trader gains and losses. 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 (30.15), which would allow you to treat your security gains and losses as ordinary income and loss.

Deducting trader expenses. 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).

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.

30.15 Mark-to-Market Election for Traders

A trader in securities may elect to have his gains and losses treated as ordinary gains and losses by making a mark-to-market election. As explained below, it is too late to make an election for 2017. In the absence of an election, gains and losses of a trader are treated as capital gains and losses on Form 8949 and Schedule D.

If the mark-to-market election is made, you report trading gains and losses on closed transactions plus unrealized gains and losses on securities held in your trading business at the end of your taxable year as ordinary gains and losses on Form 4797. Trader profits are not subject to self-employment tax (45.1), whether or not the mark-to-market election is made. The unrealized gain or loss on a security that is reported on Form 4797 increases or reduces the basis of the security. For example, if you report an unrealized gain of $50 on stock with a cost of $100, you increase the basis of the stock to $150. If you later sell the stock for $90, you report a loss of $60 in the year of the sale. The requirement to report unrealized gains and losses at the end of the year and to adjust basis of shares is an automatic change in accounting method that requires you to file Form 3115 with the IRS National Office. On Form 3115, use code #64 (the designated automatic accounting method change number), and report required adjustments; see IRS Publication 550 for details. The failure to file Form 3115 does not invalidate a timely and valid election.

Once the mark-to-market election is made, it applies to all future years unless the IRS agrees in writing to a revocation.

Making the election is not proof that you are actually a trader in securities. If you are audited by the IRS, you must be able to prove that your activities are such that you are in the business of making money by buying and selling over short periods of time. As mentioned in 30.14, there are no hard and fast rules that specify how many daily or short-term trades qualify you as a trader.

The mark-to-market election does not apply to the securities you hold for investment. Sales of your investment securities are reported on Form 8949 and Schedule D, not Form 4797.

When to make the mark-to-market election. The IRS requires you to make the election by the due date (without extensions) of the tax return for the year prior to the year for which the election is to be effective. Under this due date rule, it is too late to make an election for 2017, as this had to be done by April 18, 2017, the due date for your 2016 return. The election for 2018 must be filed by April 17, 2018.

A regulation gives the IRS authority to grant an extension of time to file the mark-to-market election if the taxpayer has acted reasonably and in good faith and allowing relief does not prejudice the interests of the government. However, the IRS has refused to allow such extensions, claiming that a late election invariably results in prejudice to the interests of the government.

The Tax Court has supported the IRS in cases where the taxpayers, in filing their elections several years late, were relying on hindsight to try to gain a tax advantage from ordinary loss treatment.

The Ninth Circuit Court of Appeals has also refused to allow a late election where the taxpayer was relying on hindsight to try to gain a tax advantage. On his 1999 return, Acar reported over $950,000 in losses from trading securities, treating them as capital losses. In early 2002, he filed an amended return and tried to make a retroactive mark-to-market election beginning with 1999 so he could treat his 1999 losses as ordinary losses and claim a refund. The IRS disallowed the late election and a federal district court and the Ninth Circuit affirmed. Allowing the late election would give Acar an advantage that was not available on April 15, 1999, the due date for making the election for 1999 under Revenue Procedure 99-17. When the late election was made, Acar knew that he had incurred losses and, with that hindsight, was trying to convert what had been capital losses on his original return into ordinary losses. It does not matter that any advantage from a late election for 1999 could be outweighed if Acar in later years realized trading gains that under the irrevocable election would have to be treated as ordinary rather than capital gains. That a taxpayer might come to regret an election in later years does not mean that hindsight was not used to gain an advantage at the time of the retroactive election.

In another case, the Tax Court was more sympathetic, allowing an extension to a taxpayer who filed his election for 2000 on July 21, 2000, three months after the IRS deadline of April 17, 2000. He had left his law practice and became a trader in January 2000. The accountant who prepared his 1999 return did not know about the mark-to-mark election but a friend told him about it in June 2000 and in July the taxpayer hired a law firm, which filed the election for him and asked the IRS to allow the extension. The taxpayer did not conduct any trading activities between the date he should have filed the election and the date he actually filed it. Over IRS objection, the Tax Court allowed the late election on the grounds that the taxpayer had acted reasonably and in good faith by promptly employing the law firm after learning about the availability of the election. Since the taxpayer did not realize any further gains or losses between the date he should have filed the election and when he actually did so, the Court held that the interests of the government were not prejudiced.

How to make the mark-to-market election. The election for 2018 is made by attaching a statement to your 2017 return by April 17, 2018 and by filing Form 3115 for an accounting method change with the return; enter code #64 (the designated automatic accounting method change number) on the Form 3115 (Section 23.01 of Revenue Procedure 2017-30). The statement with your return must specify that effective for the taxable year starting January 1, 2018, you are electing to report gains and losses from your trading business under the mark-to-market rules of Section 475(f). However, if you are not required to file a 2017 return, make the election for 2018 by placing a statement of election in your books and records no later than March 15, 2018. A copy of the statement must be attached to your original 2018 return.

One of the conditions of the election is that you must clearly distinguish between securities held for investment and trading purposes. The election applies only to the securities held in your trading business, not to the securities held for investment. Holding investment securities in a separate account is advisable.

See IRS Revenue Procedure 99-17 and the instructions to Form 3115 for further details on making the mark-to-market election. In light of the accounting requirements and the overall effect of reporting unrealized gains and losses, before making the election you should consult a professional experienced in the use of mark-to-market accounting.

Revoking the election. An election can only be revoked as an automatic change in accounting method (code #218 is the designated automatic accounting method change number). Details about the revocation procedure are in Revenue Procedure 2017-30 (Section 23.02).