|Stock transaction tax rules for Day Traders
IRS demands day traders record every transaction
If you're a day trader, you know all about risk. But here's one sure thing -- the IRS wants a mound of paperwork from you.
Most taxpayers aren't true day traders, but investors. To be a trader -- and to qualify for the special tax treatment that traders get -- you must profit primarily in swings in daily market movements, and personally engage in the purchases or sales.
Taxpayers who spend a lot of time trading, especially those who don't have full-time jobs, are more likely to qualify as "true" day traders in the eyes of the IRS. Basing trades on profits from short-term market changes as opposed to long-term gains and dividend income also increases the chance of being perceived as a trader by the IRS.
Once you attain trader status, the IRS has special rules for you, some favorable, some less so.
The favorable ones give traders a break on capital losses.
Most taxpayers who sell a stock at a lower price than they paid for it incur a capital loss. The loss reduces part of the taxes they owe.
If someone buys and sells the same stocks a lot, though, there is a problem. Generally, anyone who purchases the same stock 30 days before or after selling it transforms the sale into a "wash" in the eyes of the IRS. This could make it impossible for someone who is constantly flipping over stocks to ever claim a loss.
The IRS gives a break to day traders, however. They become "mark-to-market" traders and are exempt from the wash-sale rule.
How does this work? On the last trading day of the year, a day trader pretends to sell all holdings. He records all sales and gains that result, even though he still owns the stocks. His new year begins without any capital gains or losses. The trader then pretends to "buy back" all of the stocks that he never sold.
There is another tax break for mark-to-market traders. Most stock investors can only claim up to $3,000 as a capital loss in a given year. If someone is a mark-to-market trader, though, there isn't a limit on capital losses. This doesn't eliminate all the pain from a bad year, but it should ease it a bit.
The paper chase
Now, the really fun part. A lot of trading is bound to mean one thing to the IRS -- a lot of paperwork.
It doesn't stop at the loss or gain from each trade. The IRS expects all the details from every transaction, including each security's description, purchase date, cost, sales proceeds, and sales date.
Traders have two ways they can approach this task -- do it by hand, or with a computer assist.
Taxpayers can report their trades by hand on Schedule D. Anyone going this route will have to record every single trade, reporting net short- and long-term gains and losses, total sales proceeds and the total cost of shares. If you're going this route, you should also attach a statement offering to provide details on request.
If this sounds like a nightmare, it could provide the push you need to use a computer program for your taxes. Financial software such as Intuit's Quicken or Microsoft's Money allows you to download trading data from several online brokers. You can then use a tax program such as Kiplinger TaxCut to transfer all the data onto your tax return.
Not only is the computer route likely to take less time, but it could prevent some unwanted scrutiny from the IRS. Keep in mind that the IRS is going to be trying to reconcile a tax return completed by hand with any information reported by your broker. Overlooking a trade or incorrectly reporting a detail could mean having to spend a day answering questions from the IRS. And, of course, that could be the one day that you make a killing in the market.
Capital losses can help cut your tax bill
Plummeting stock prices can cast a dark cloud over anyone's finances. However, at tax time, the write-offs for these capital losses can be a ray of sunshine. So if you sold any dot-com dogs or biotech blunders at a loss this year, you can use them to offset gains from more successful ventures -- or even a portion of your everyday income.
A capital loss is the result of selling an investment at less than the purchase price or adjusted basis. Any expenses from the sale are deducted from the proceeds and added to the loss. The key point is that capital losses are only losses after you sell them. A stock sitting in your portfolio with a deflated price may cause you distress, but it doesn't factor into the tax issue. The sale of personal use property, such as a car, can't be deducted as a capital loss.
You can recoup a percentage of a true loss from the taxman. This is one of the best deductions available to investors. A capital loss directly reduces your taxable income, which means you pay less tax. It makes for a nice consolation prize.
How it works
It's touching that the Internal Revenue Service wants to give you a break when the stock market tanks. However, this doesn't mean the weighing and applying of capital losses is simple.
When filling out Schedule D, you'll discover that losses are categorized as short-term and long-term, just like gains. The value of the deductible loss depends on how the loss is applied. Sadly, the taxpayer doesn't get to choose.
Here's how it works:
- Short-term losses counter-balance those expensive short-term gains. What's left at the end of section I of Schedule D is the net short-term capital gain or loss. If there were no gains, then obviously the net would equal the total loss.
- Long-term losses are applied to long-term gains. The result at the end of section II of Schedule D is the net long-term capital gain or loss. Again, if you only have a loss, then the net is a negative number.
- Next, you combine the short-term and long-term results. At this point, a loss in one section can offset a gain in the other section. For example, if you have a net short-term loss of $1,000 and a net long-term gain of $1,200, then you'll pay tax on only $200.
- If the total is a gain, you'll be paying taxes on that.
- If there's still a loss, you can deduct up to $3,000 from other income.
- If you had a really bad year and ended up with a net loss of more than $3,000, you can carry forward the leftover portion to next year's taxes. The unused loss can be applied to next year's gains as well as up to $3,000 of earned income. A big loss can be used as a deduction indefinitely -- another important reason to keep good records.
Timing is everything
While many factors will affect your choice to sell a security, tax considerations can be a major component of such a decision.
- Capital losses are best taken in a year with short-term capital gains or no gains, because you will save on your full ordinary income tax rate. The tax consequences of a short-term capital gain can send you looking for a devalued stock to purge from your portfolio. Dump the losers; enjoy the tax break.
- Long-term capital gains have an attractive low tax rate (20 percent for most investors), so the benefit of a deductible loss is much less.
Wash away those losers?
But what if the only deflated stocks in your portfolio have a lot of promise to rebound to profitable glory? You might think of selling something off to create a loss, and then repurchasing the stock so you can ride it back up.
Not so fast, bucko. The IRS is a step ahead. The tax folks closed up that loophole with something called the Wash Sale Rule. The catch is you can't claim a loss from the sale of a security and then turn around and buy a substantially identical replacement within 30 days.
For example, if you sell a stock and then pick it up again a week later after it splits, the IRS knows it's still the same stock. So, if you want the tax break, you have to take a risk and wait 31 days to pick up that stock or security again.
For a more subtle way to work within the Wash Sale Rule, you could sell shares of one company's mutual fund and pick up the same type of fund from another company. For example, sell off Vanguard Health Care mutual fund and then buy into Fidelity's Heath Care mutual fund. For bonds, be sure to buy a new one that differs from the old one in one or, even better, two criteria: issuer, credit rating, maturity and yield.
Though capital losses can lessen the pain from a gain, they are not the way to wealth. Your ideal financial scenario would be for every stock to be a long-term winner. But for that you need a crystal ball, not a tax form.
IRS rules grant extra deductions to those high-rolling day traders
With the advent of do-it-yourself Internet brokerages, a new occupation arose that blends Wall Street investor and high-risk gambler -- the day trader.
For tax purposes, however, the Internal Revenue Service draws a distinction between day traders and investors -- and treats them very differently on April 15.
Time, intensity and goals are keys
While more of us use the Internet to track, monitor and trade stocks, most taxpayers aren't true day traders. Most are investors in the eyes of the IRS.
This distinction matters at tax time: Investors' expenses are itemized deductions, day traders have deductible business expenses.
What does it take to be a day trader? According to a Q&A from the IRS, true traders buy and sell securities frequently, but engaging in extensive trading isn't enough. To be a trader, you must profit primarily from swings in daily market movements and personally engage in the purchases or sales.
Time, intensity and profit goals help the IRS draw the line between investors and traders. Taxpayers who spend a lot of time trading, especially those who don't have full-time jobs, are more likely to be considered traders. Basing trades on profits from short-term market changes, as opposed to long-term gains and dividend income, also will increase your chances of being perceived as a trader by the IRS.
Investors and Schedule A
If, like most taxpayers, you're not a trader, the IRS will consider your expenses in this area to be the miscellaneous itemized sort. Account for them on Schedule A.
After combining your investment expenses with other expenses, such as those for tax preparation, you will only be able to write off whatever amount of the total exceeds 2 percent of your adjusted gross income. Use Schedule D to account for your gains and losses.
Investors cannot use their trading activities to claim many of the deduction perks that are available to true day traders. However, they can use any interest paid on a margin account to offset income earned from their investments.
Traders, deductions and Schedule C
If you do meet the IRS tests for traders, you can deduct expenses that arise from your trading activities.
The first piece of good news is that you are considered self-employed. You get to deduct expenses, such as interest on your margin account, on Schedule C. These write-offs have the added benefit of reducing your adjusted gross income. Reducing this could qualify you for a number of other income sensitive deductions.
Day traders also are likely to qualify for two other tax savings for sole proprietors. Any personal equipment used primarily (at least 50 percent of the time) in trading activities qualifies for a Section 179 write-off. This allows a taxpayer to deduct up to $19,000 in expenses this year instead of having to spread them out over time. In addition, if you use a room in your home regularly and exclusively for trading, you can probably take advantage of a home office deduction.
Be careful, though. The tax benefits associated with true day trading aren't enough to offset the financial risks for everyone. Think twice before you quit that day job.
Wrong investment basis could cause bigger tax bite
No one wants to pay the same tax twice, but that's exactly what a lot of people do when they don't correctly figure the cost-basis of the stocks or mutual funds they sold.
This is a particular concern if you reinvest dividends and capital-gains distributions rather than take the earnings in cash. These transactions increase the basis, or tax value, of your investment.
The basis amount is crucial in determining any capital-gains tax bill you owe when you sell your holdings. It also could add to any capital-gains tax loss you want to use.
Adding up all of your investment
Generally, you subtract the price you paid for an asset from its sale price to arrive at your taxable basis. But, reinvested earnings affect basis. Here's how it works:
You bought 100 shares of a stock for $1,000 in 1999, and that year had dividends of $100 reinvested. In 2000, you got $200 in dividends and capital gains distributions, again reinvested.
Tax law considers these reinvested earnings as paid to you even though you don't actually have the cash in your hand. They are reported on Form 1099-DIV and you must pay taxes on the amounts in the years you receive them, either as regular income or capital gains.
In 2001, you sold all your stock for $1,500. Here's where your reinvested dividends can help reduce your taxable gains.
Take your $1,000 original purchase price and add the $300 that you reinvested -- and already paid tax on -- over the years. This gives you an adjusted cost basis of $1,300. This is the amount you subtract from your sale price of $1,500, meaning you have taxable gain of only $200 instead of $500.
If you don't account for reinvested distributions, you'll end up giving Uncle Sam tax money a second time when you sell.
Losing the loss value
And if you're looking to take advantage of a capital loss to reduce other gains, a wrong basis amount could cheat you out of the full benefit of that tax advantage.
For example, let's say in the scenario above you sold your stock for $800, thinking you'd use the capital loss to offset gains you made on another holding. However, you're not getting the best possible tax loss unless you take into account your reinvested earnings.
If you simply subtract your original investment of $1,000 from your sale proceeds of $800, you get a $200 loss. Your true loss is larger:
|Minus adjusted cost-basis
|Equals capital loss
That extra $300 in losses could make a difference in your final tax bill.
Complete records mean correct basis
To make sure you don't overpay the Internal Revenue Service on your investment gains or lose out on a valuable tax-loss deduction, hang on to all your stock and fund account statements.
These documents will show you exactly how much in additional purchases, either directly or with reinvested funds, you made during the life of your account. This will help you figure the correct cost-basis to calculate a capital gain or loss.
The paperwork collection may mean an extra folder in your filing cabinet, but it also could mean extra cash in your wallet at tax time.