Unlike investors, securities traders are deemed to be conducting a trade or business, so their trading expenses are deductible as ordinary and necessary business expenses under IRC Sec.î 162. Thus, the difference brings along many differences of how a day trader will pay tax on their trading gains and be able to deduct trading losses.
What are a trader’s business expenses?
A trader’s business expenses include interest paid on margin accounts used in connection with the trading activity. This is much different than ordinary investors. However, if the taxpayer does not materially participate in the trading activity (e.g., a limited partner in a trader partnership), interest incurred in the activity is subject to the investment interest expense limitation. In addition, a trader’s business status makes him or her eligible for claiming a home office deduction, provided that the other home office deduction criteria are met. Individuals report their trading expenses (including interest on margin accounts) on Schedule C of their annual tax returns.
Special Assets Held by Day Traders
Traders may acquire assets that qualify for Section 179 expensing. Traders will generally show a loss on their Schedule C (since the gains from trading are reported on either Form 8949 and Schedule D, or if a mark-to-market election is made, on Form 4797). Although the annual Section 179 deduction is limited to taxable income from a trade or business, practitioners should not confuse taxable income with income shown on Schedule C.
What are Day Trading Gains?
The authors believe that the trading gains and losses are included in taxable income for the Section 179 limitation. Reg.î1.179-2(c) defines taxable income as the aggregate net income (or loss) from all of the trades or businesses actively conducted by the individual. Furthermore, business income for this purpose includes Section 1231 gains (or losses) from the trade or business and interest from working capital of the trade or business. Thus, income clearly can include items other than those reported on Schedule C.
What happens when a trade disposes of stock?
When a trader disposes of a stock, the general rule is that the sale is treated as a short-term or long-term capital gain or loss, depending on how long the stock was held. This capital asset treatment occurs because traders do not have customers to whom they sell stock; therefore, their stock does not meet any of the exceptions to capital asset treatment under IRC Sec. 1221. Thus, traders generally report their stock gains and losses as capital gains and losses on Form 8949 and Schedule D and, accordingly, are subject to the $3,000 annual limitation that applies to net capital losses under IRC Sec. 1211(b) and the wash sale rules. The Section 1091 wash sale rules can be particularly detrimental to traders because they defer the recognition of a stock loss when the taxpayer acquires the same stock within a period beginning 30 days before and ending 30 days after the date of sale.
Benefits of Mark-to-market Election for Day Traders
As an alternative to capital asset treatment, IRC Sec. 475(f) allows traders to elect to mark their stock holdings to market at the end of the tax year. If the election is made, all security gains and losses are treated as ordinary income and all securities on hand at year-end are deemed to be sold at the year-end market value, thus recognizing unrealized gains and losses. For traders, the primary benefit of making the election is that the $3,000 limitation on net capital losses and the wash sale rules no longer apply. Conversely, the trader is no longer allowed to treat trading activity gains and losses as capital asset transactions, but this should have minimal negative impact since traders by definition should have few, if any, long-term capital gains.
Using Mark-to-market Election for Day Traders
Because capital gains and losses are specifically excluded from the definition of net earnings from self-employment (SE), earnings from a trading activity are not subject to the SE tax. A Sectionî 475 mark-to-market election converting the gains and losses to ordinary income does not change their status for SE tax purposes. However, since a trader’s net earnings are not SE income, he cannot contribute to a retirement plan (e.g., SEP or IRA) based on such income.