Wait! Read This Before Your File Your Taxes
Now that you’ve had a little break — ready to jump back into our tax day terms?
I know taxes already are stressful. But remember, day traders have much more to consider than the average person. You can’t just enter your W-2 into some tax software, sit back, and wait for the results.
There are a lot more moving parts to consider.
So without further ado, let’s get right back into it:
Capital Gains & Capital Losses
We already talked about what these terms mean, so we don’t need to cover it again.
What we do need is to learn how to report your capital gains and losses on your taxes. It’s not as straightforward as you might think … and it involves a few different forms.
Which forms you need depends on whether you made the mark-to-market election last year (I’ll talk about that more in a sec).
If you’re a new trader, you probably didn’t. You’ll need to report your capital gains and capital losses on Form 8949 and Schedule D.
Trading expenses go on Schedule C. This form doesn’t reflect your revenue, so it looks like you’re only reporting a loss. To fix this, it’s recommended that you include a statement indicating that your net trading gains are shown on Schedule D.
Trader or Investor: Know the Difference
The IRS sees everyone who trades as either a trader or investor.
You might not think it’s an important distinction, but people who qualify as traders can save some serious money on tax day.
Are You a Trader?
How do you know if you qualify for these tax benefits? Well, that’s the tricky part.
The IRS couldn’t be vaguer in its explanation of the requirements. The IRS says your trading activity has to be substantial and consistent. And that’s as specific as it gets.
You can probably see why this presents some problems. Taxes are serious business — you don’t want to make any false assumptions.
In any case, there’ve been several court cases on the topic, which gives us a better idea of what it means to qualify as a trader.
Substantial, Constant Activity
The primary requirement is that you spend a lot of time trading and that you do so consistently.
Again, there’s no set amount of hours or anything, but the more, the better. If you don’t have a job and you trade full-time, that definitely helps. It’s harder to argue that you aren’t a trader if that’s how you make a living.
You can also be a part-time trader, but you should be making several trades on a daily basis in that case.
Your trading also shouldn’t be sporadic, like one day here and there. You can take occasional breaks, but, for the most part, you should make several transactions per day throughout the year.
Did You Make a Profit?
Turning a profit might not be a requirement, but can help make your case.
An important thing to remember is that the IRS treats traders the same way it treats businesses. As far as businesses go, tax law says that they should typically be profitable for three years in a five-year period.
Again, this may not be the deal breaker. Maybe you haven’t even been trading long enough to meet this requirement, but it’s definitely not gonna hurt.
Can You Be a Trader and an Investor?
Short answer: Yes.
Longer answer: Yes, but with a caveat.
To be classified as a trader, your goal should be to profit from short-term market movements. Investors make money from dividends and long-term gains. If you hold several long positions, it can weaken your case as a trader.
To be both a trader and investor, you should separate your long-term positions. That means you identify them as such in your records on the day you purchase them.
If you meet all of these criteria, there’s a good chance you qualify as a trader. If so, congratulations, you just might save some cash.
Schedule C Deductions
Bonus for those of you who qualify as a trader: The IRS sees traders as self-employed buyers and sellers of securities.
Just like any other sole proprietor, you can deduct your trading-related expenses on Schedule C.
These deductions will also reduce your adjusted gross income. This means you could potentially qualify for more tax breaks.
One of the great things about achieving trader status: the mark-to-market election.
Again, if this is your first year filing taxes as a trader, this probably doesn’t apply to you. But keep reading — you might be able to reap the benefits next April.
Here’s how it works: On the last trading day of the year, you have to pretend to sell and repurchase your entire portfolio. You record your imaginary gains and losses, which allows you to start the new trading year with no unrealized gains or losses.
The mark-to-market election has some great advantages.
First, you’re exempt from the wash-sale rule. This can save you a ton of bookkeeping trouble. And that frees up time that you can then spend focusing on trading.
Next, remember how I mentioned earlier that the amount you can deduct in capital losses depends on your tax status …
Most people can only deduct up to $3,000 in net capital losses each year. This limit doesn’t apply to mark-to-market traders. Mark-to-market traders can deduct an unlimited amount of capital losses.
You might not like to think that you’ll lose enough for this to matter, but it happens all the time. In a bad year, this might help undo some of the damage.
Forms for Mark-to-Market Traders
As a mark-to-market trader, the IRS allows you to report all of your capital gains and capital losses as business property.
You should do this on Part II of IRS Form 4797.
This two-day guide contains a lot of the information you need to prepare for tax day. But everyone has different financial circumstances that can affect how they need to file their taxes.
Don’t wait for the last second to get professional guidance on your particular situation.
It’s important to get taxes right. No one likes to be on the wrong end of IRS scrutiny … Do your research, talk to a professional, and maintain clear records to help you prepare for tax day.
— Tim Sykes
Editor, Penny Stock Millionaires