Trade for a living? Get info to stay out of trouble with the IRS. Learn about mark-to-market and unique trader taxes that impact full-time traders’ bottom lines.
By Ticker Tape Editors February 7, 2023 4 min read
4 min read
Photo by TDAmeritrade
Key Takeaways
- If you meet a set of conditions to be engaged in business as a securities trader, you may qualify for unique tax considerations
- You may be able to deduct any expenses related to your trading business
- You are allowed to write an unlimited amount of losses against your profits
You’ve finally taken the leap into the world of full-time trading, and like all good traders, you want to take advantage of any edge that might help increase your profitability. So, let’s talk about trader taxes. Uncle Sam needs his slice, but your strategy can help determine the size of his piece. That’s right: There are unique tax considerations for those who trade for a living, and that can greatly affect your bottom line.
First, let’s make sure you don’t run afoul of the Internal Revenue Service (IRS). In fact, the IRS has very strict rules to determine whether you qualify—by its standards—as a full-time trader and are entitled to use what is informally referred to as the “trader’s election.”
From the IRS:
Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
- Your activity must be substantial.
- You must carry on the activity with continuity and regularity.
The following facts and circ*mstances should be considered in determining if your activity is a securities trading business:
- The typical holding periods for securities bought and sold.
- The frequency and dollar amount of your trades during the year.
- The extent to which you pursue the activity to produce income for a livelihood.
- The amount of time you devote to the activity.
If your trading activities do not meet the above definition of a business, you’re considered an investor and not a trader. It doesn’t matter whether you call yourself a trader or a “day trader.”
If you feel you fully meet the above criteria, you could choose to take the “mark-to-market election,” which must be claimed for the current year when you file your taxes from the previous year. Mark-to-market means you treat a trading position as closed at year-end and account for any gains or losses based on the marked value. When the position is later sold or covered, the cost is adjusted to the marked value. Traders are required to file a Form 3115 (Application for Change in Accounting Method). IRS Publication 550 describes the procedures in making this election with the IRS. So, to take the election in 2023, you would’ve had to file a statement to that effect with your 2022 income tax return either by the April or October tax deadline if you requested an automatic extension. As far as the IRS is concerned, for tax reporting purposes, full-time traders have no open positions come December 31. The mark-to-market price is used againstyour cost basisto determine if you have a profit or loss on those positions. You’ll also want to consultIRS Topic 429and your tax advisor to better understand“wash sale” ruleimplications for full-time traders. When trading for a living, you can deduct any expenses related to your trading business, including the cost of software, subscriptions, data feeds, educational tools, and even your computer if you use it more than 50% of the time for your trading. But the biggest benefit is that you’re allowed to write off an unlimited amount of losses against your profits—your de facto earned income. This is a huge advantage. Compare that to an investor with $50,000 in earned income (taxable wages, for instance) and $20,000 in trading or investing losses; the investor can only deduct $3,000 of those losses, leaving them with $47,000 in taxable income. As a full-time trader, with the mark-to-market election in place, if you have $50,000 in profits, you can write off all $20,000 of your losses, leaving you with only $30,000 in taxable income. Keep in mind, the $30,000 left over is treated as ordinary income (which could bump a filer to a higher tax bracket). There is also the potential to incur self-employment tax on the business’s net income. Mark-to-Market
Now, the Benefits
What About Reversing Status?
If you want to revoke your trading-as-a-business status, IRS permission is needed by filing Form 3115 to request the dissolution of trader status. The IRS is not likely to grant permission if the request is made solely to achieve tax bill benefits. Grants are more likely to be issued if the taxpayer is no longer trading as a career.
And traders, who also invest using longer-term strategies, may want to have a separate account in which they hold positions for capital appreciation or dividend income. A trader would not file Form 8949 for the elected account; instead, Form 4797 should be filed. Traders who have both types of accounts (investor and trader) would file an 8949 and a 4797.
As with all tax issues and planning, you should always seek the advice of a professional before you do anything. They can help you better understand the unique tax considerations and potential advantages or disadvantages for full-time traders as well as file any needed documentation with the IRS.
By Ticker Tape Editors
TDAmeritrade
Key Takeaways
- If you meet a set of conditions to be engaged in business as a securities trader, you may qualify for unique tax considerations
- You may be able to deduct any expenses related to your trading business
- You are allowed to write an unlimited amount of losses against your profits
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As someone deeply immersed in the world of full-time trading, I can unequivocally affirm the critical importance of understanding the intricacies of trader taxes. The recent article by Ticker Tape Editors, dated February 7, 2023, sheds light on the unique tax considerations that impact the bottom line of individuals trading for a living. Let's delve into the key concepts discussed in the article and provide additional insights:
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Qualifying as a Full-Time Trader: The IRS imposes strict conditions to determine whether an individual qualifies as a full-time trader. These conditions include:
- Seeking profits from daily market movements.
- Engaging in substantial and continuous trading activity.
- Considering factors like holding periods, trade frequency, and the time devoted to trading.
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Trader's Election and Mark-to-Market:
- Full-time traders who meet the IRS criteria have the option to make the "mark-to-market election."
- Mark-to-market involves treating trading positions as closed at year-end and accounting for gains or losses based on marked values.
- To take this election, traders must file Form 3115 (Application for Change in Accounting Method) and adhere to IRS procedures outlined in Publication 550.
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Tax Reporting and Wash Sale Rules:
- For tax reporting, full-time traders are considered to have no open positions by December 31, with mark-to-market prices used to determine profits or losses.
- Traders should be aware of the implications of the "wash sale" rule, and IRS Topic 429 provides additional guidance.
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Expense Deductions for Traders:
- Full-time traders can deduct various expenses related to their trading business, such as software costs, subscriptions, data feeds, educational tools, and even computer expenses if used more than 50% of the time for trading.
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Unlimited Loss Write-Offs:
- Perhaps the most significant advantage for full-time traders is the ability to write off an unlimited amount of losses against profits, treating them as earned income.
- This stands in contrast to investors who may face limitations on deducting losses against other income.
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Reversing Trader Status:
- Traders who wish to revoke their trading-as-a-business status need IRS permission and must file Form 3115.
- IRS is unlikely to grant permission solely for tax benefits, and traders transitioning away from trading as a career may have a better chance of approval.
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Separate Accounts for Trading and Investing:
- Traders employing both short-term and longer-term strategies may consider having separate accounts.
- Different filing forms (8949 and 4797) apply depending on the type of account and trading activities.
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Professional Guidance:
- The article emphasizes the importance of seeking professional advice for navigating the complex landscape of trader taxes.
- Professionals can help traders understand unique tax considerations, advantages, disadvantages, and ensure proper documentation for the IRS.
In conclusion, mastering the nuances of trader taxes is not just a matter of financial prudence but a strategic imperative for those navigating the challenging terrain of full-time trading. It's a game where knowledge is the ultimate currency, and being well-versed in tax intricacies can be the edge that sets a trader apart in the pursuit of profitability.