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Why you should file taxes as an active trader

Posted by Satuki On March - 21 - 2010

I have been filing my tax returns as an active stock trader  for a couple of years.  I can tell you that there are a lot of advantages to file as an active trader than a regular investor. This post is not to teach you how but why. Once you understand why it is much better to file as an active trader, you should consult with a qualified tax preparer who has good knowledge of active trader taxes. 

 

As an investor, you are faced with a lot of restrictions when filing your taxes.  Here are a few serious ones

  1. $3000 annual cap on losses
  2. limited deductions in investment/trading related expenses
  3. wash sale rules

 

The first one is perhaps a big headache for a lot of new traders or investors.  When one just starts out, he is bound to have a couple of losing years, which tend to be quite big.  Let’s say if you lost 30k in 2009 and you filed your taxes as an investor. You also have a regular job from which you pull in about 60k annually.  Due to the $3000 cap, you can only deduct $3000 from your 60k.  In other words, your taxable income in 2009 is 57k. I do not know why the IRS has this 3000 cap rule for the investors. But it certainly sucks for 2 reasons. First, you have only 30k in your pocket due to the loss in 2009 and yet you have to pay taxes for 57k.  Second is that it will take you 10 years to finish the  deduction if you do not recover in your losses from the market in the following years.  I am not kidding you.  More people than you think will quit after a few consecutive years of losing.

 

The second is that you are limited in deductions of your investment related expenses as an investor. Can you deduct the cost of all your trading equipment such as your computer, 2 24 inch LCD monitors and a Herman Miller chair?  Can you also deduct your expenses on a trading/investing monthly subscription, books, seminars, high speed Internet?  Can you claim a deduction on a portion of your home if you operate from your basement or just a room? 

 

The third is the wash sale rules. A lot of people perhaps already know what it is.  It is a pain in the neck.  You can not buy/short the same or similar stock within 30 days before or after you sold it for a tax loss treatment. That is a span of 60 days.  What if there is a very good set-up in that window?

 

As an active trader with mark to market accounting method elected, the 3 rules above do not apply to you. That is

  1. There is no loss cap
  2. You can claim a deduction on any expense related to trading
  3. No more wash sales rules

 

Now you see the disadvantages of filing as an investor. But before you rush to file as an active trader, do you qualify?  The IRS has a loose set of rules for the Trader Status(business trader).  You can download the IRS publication 550 here http://www.irs.gov/pub/irs-pdf/p550.pdf .   Find the section “Special Rules for Traders in Securities”.


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  • rogerwillcox
    Ha, by blind luck. I called my CPA on friday to ask about my return and drilled him with questions. He is normally very responsive and informative however... He was still a bit uneasy with my trading activity and wanted to file an extension. HE HAD MY INFO SINCE Feb! Anyway, he did refer me to a place called boyer tax services that only does traders returns. I got my completed return TODAY! Finally, the trader tax bs is over and now I can focus on trying to make sense of this market...
  • I didn't realize the US had such restrictions... wow.
  • Market Monk
    Sorry, you can not do what you want to. http://www.fairmark.com/traders/mtmacc.htm

    Plain and simple. To have the MTM election take effect for 2011 you have to do so by making the request by this April 15th (2010). You can not go back and refile your taxes.

    But I would highly suggest that you give this election some serious thought as well as contact the folks at the link above or these folks: http://www.greencompany.com/

    I don't have the time to go into the downsides, but those two sites I referenced will have plenty to say.

    Best of luck to you.
  • ciara
    I been actively trading for 3 years and just now heard about this since I didn't do market to market the last 3 yrs can I amend my tax return to redo it over market to market or am I screwed I had large losses this would really suck if I can't btw what are the disadvantages of market to market
  • Perhaps not since you need to elect MTM one year ahead.

    One downside of MTM is that market value might not truly reflect the value of an asset, for example stocks in 2008 and early 2009
  • Oh man, even more complications regarding filing tax returns. Just think how fun it is to prepare a tax return for those active trader (non MTM), who trad stocks, ETFs (I hate UNG and any ETF that gives you a K1), options, futures, forex, mutual funds!!!!
  • rogerwillcox
    LOL, yeah I agree! I do a large amount of covered calls and my accountant has to match the option symbol with the stock to calc the wash sales... I have over 12k transactions. His assistant told me that since I became a client he lost all of his hair!
  • 12k transactions, Wow, I'd lose all my hair too if MTM is not used. I still remember when I tried to use Turbo Tax and filed for capital gains(Wash sales rules), Turbo Tax hanged due to the huge number of trades. I had to switch to TradeAccountants for that. Paid 99 bucks for a one time calculation back then
  • rogerwillcox
    Yeah I used the Trade Accountant Pro from Sync E. It did do a good job for a couple people in my trading group, but I had way too much data to manipulate. So long as the related stocks and options are paired, but even that is way tooo time consuming. I think my CPA used trade log for most of his recon.
  • Market Monk
    If that is so then I have to assume you have not elected the MTM accounting. If not, why not?
  • rogerwillcox
    I made a change of accounting method, so the m2m will be active for 2010. But I am still taking advantage of all the deductions including short term education which an investor cannot. What I am trying to say is that using an LLC as a partnership does not raise the same questions that you discussed above. The only item we cannot deduct is medical inside a partnership.
  • It's the most confusing subject that traders have to deal with. And the MTM election is one that needs to be considered carefully. Those who predominately trade futures will not want to take the MTM election because futures are already marked to market nightly. But the big reason is that futures have the nice tax advantage, that being 60% of the profits are taxes at long term rates, with the remaining 40% tax at short term rates. For those who trade a mixture of futures and equities it's a tough decision to make. Not sure how the MTM election affects Forex trading (if at all).
  • Tax filing is extremely simple for futures traders. I traded features briefly a couple years back and lost a bit money and backed out.

    Forex tax code is confusing and uncertain, making tax filings difficult for forex traders. Some types of forex trades are treated as Section 1256 contracts with lower 60/40 tax treatment (after filing a timely internal capital gains election), and other forex trades are, by default, treated as Section 988 foreign currency transactions with ordinary gain or loss treatment.
    See the full article here http://www.greencompany.com/EducationCenter/GTT...
  • TM,
    What I was trying to say is that:
    1) you as an individual determine whether or not you qualify as a trader (the IRS does not grant you this status, they just provide a loose definition).
    2) Investors and traders have to be concerned with wash sale rules and are limited to the $3,000 cap.

    It is true that once an individual determines they qualify as a trader, they can then start deducting all of their expenses and not have to worry about the 2% threshold of AGI.

    It is the "trader" that elects MTM accounting that then get's the benefit of not having to deal with wash sale rules as well as is no longer capped at $3,000 of losses applied to ordinary income.

    Please do bring up the downsides to electing MTM in your next post.

    Hopefully this clears things up.

    I have to say that I hate this entire topic as it would be so nice to not to have to deal with any of these issues. They are outdated in my humble opinion. And it is so confusing to say the least.

    Keep up the great work. I enjoy reading your articles. How is your forex trading coming along?
  • It is indeed very confusing. That is why I encourage most people to talk to a qualified tax guy. I know MTM is very important. I thought anyone who files as an active trader would default to MTM. I left it out in the post. I have added it. Thanks for that.

    My Forex trading is very slow. I do like it though. My current model is day trading stocks and swing trading Forex since I am scared by the gap ups/downs in the stock market
  • TM,

    I have to say that your post implies that you can file with the IRS as an "active trader" and I know of no such classification. In the eyes of the IRS you are treated the same as an investor. An Investor, occassional trader, or hyper active trader are all the same. They all have to worry about the wash sale rule, can only deduct $3,000 of losses against ordinary income, file capital gains on schedule D.

    It is only someone who believes that they are a "trader" in the eyes of the IRS (and are willing to fight for this status, as IRS does not grant someone this status) can elect to have the MTM accounting and therefore get those benefits I mentioned in earlier posts.

    One of my friends alerted me to your post and it was confusing to him.

    So in my humble opinion you are wrong when you state an "active trader" does not have to worry about the 2 of 3 things (no cap loss, and wash sale rules).
  • rogerwillcox
    No offense MarketMonk or Satuki. what you say in this post is not always correct. I setup a trading LLC with me and my partner and was involved in an audit. The IRS said all of our books were in order and we treated it as a separate legal entity apart from our self thus no question even came up about trader status. I do agree with you though about having a professional. We would have never beat the audit if we did not reply on our CPA from Boyer Tax Services. I am not a master in business and have very sloppy record keeping skills :) Anyway, great site and great information. - Roger
  • I file as a sole proprietor. Setting up a trading LLC is better if you have enough energy to handle it since it brings you all kind of goodies such as having your own 401k, fully deducting your health insurance . Also I heard someone say that you could sock away 40K every year for your ROTH account, comparing that to 5k for an average Joe.
  • Market Monk
    I would like to understand what parts you feel are incorrect. Keep in mind Satuki was not speaking about using a business entity.
  • >>In the eyes of the IRS you are treated the same as an investor. An Investor, occassional trader, or hyper active trader are all the same

    I think you are wrong here. "Before you are are able to use Trader status benefits(i.e business expenses and the opportunity of elect market to market accounting), you first must qualify as a trader in the eyes of the IRS". This is what Robert A Green from http://www.greencompany.com said. Robert is definitely an authority on this topic. Robert A. Green, CPA is a Contributing Writer for Active Trader Magazine, the leading monthly magazine for active traders. Mr. Green writes their "Business of Trading" column.

    So there is a classification called "Trader Status " or "Trading as Business" in the eyes of the IRS . The IRS does not grant this status before hand does not mean there is no such a classification.
  • Johnny
    Satuki

    Would you mind sending me a reference showing an active trader is not subject to self employment tax. Interesting subject.

    Thanks

    Johnny
  • you can find it near the end of this publication from the IRS http://www.irs.gov/pub/irs-pdf/p550.pdf
  • And by the way you also need to elect MTM accounting if you want to deduct more than $3,000 of losses.

    So did you forget to mention that you elected this accounting method?
  • All true. MTM coverts your capital gains/losses to ordinary gains/losses. I was saving all this info for my second post.

    The purpose of this post is to remind people of the importance of filing as a trader, who qualify for the trader status. Some people are DIYers, like myself. However, I would encourage most to find a professional tax preparer because it takes quite a bit time to DIY.
  • Trader Mom,

    You need to elect Mark to Market accounting to be exempt from the wash sales rules. Being an active trader is not enough.

    Keep in mind that you have to "elect" the MTM accounting method by 4/15 of this year to have it take effect in 2010. It's too late to do so for 2009 tax season.

    Hope this helps.

    MM
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