Taxes are one of the most confounding hoops for day traders to pass through when reporting profits and losses. Whether you’re trading full-time to make a living or just trying to shore up some cash for your long term savings goals, there are a huge variety of tax implications to consider.
Below are the some of the basics about trading and taxes that can help you optimize your trading strategy and best navigate your compulsory payments to Uncle Sam.
Day Trading Taxes - How To File
For those entirely new to financial markets, the basic distinction in tax structure is between long- and short-term investments. Long-term investments, those held for more than a year, are taxed at a lower rate than trades held for less than a year, which are taxed at the normal income rate. You can see a full breakdown of the rates in the chart below.
|Gross Annual Income||Long-Term Tax Rate||Regular Tax Rate|
|Up to $9,325||0%||10%|
|$9,326 to $37,950||0%||15%|
|$37,951 to $91,900||15%||25%|
|$91,901 to $191,650||15%||28%|
|$191,651 to $416,700||15%||33%|
|$416,701 to $418,400||15%||35%|
|$418,401 or more||20%||39.6%|
The takeaway is that, for accounting purposes as well as a variety of practical reasons, traders should maintain separate accounts for day trading and building a long-term investment portfolio.
In addition to capital gains, both traders and investors can report a small portion of their losses in a year, just $3,000. Traders must provide receipts on the specific trades they claim as losses and, in what’s called the wash sale rule, cannot hold shares of that stock 30 days before or after the holding period they wish to claim them on a tax refund.
Any losses over $3,000 can’t be claimed and are simply carried forward as a straight loss.
Trader Tax Status Designation
For most light-to-moderate traders, that might be the extent of the tax primer. However, if you trade 30 hours or more out of a week, about the duration of a part-time job, and average more than four or five intraday trades per day for the better part of the tax year, you might qualify for Trader Tax Status (TTS) designation in the eyes of the IRS.
The designation is not guaranteed, but you can check out the IRS webpage for more information on TTS. This designation opens up a lot of opportunities for tax efficiency, because professional traders can report their trading income and liabilities as Schedule C business expenses. The direct benefits to this designation include the ability to deduct items such as trading and home office expenses.
The most drastic difference in having TTS designation is the ability to deduct losses beyond the $3,000 allowed as capital losses. TTS designated traders must make a mark-to-market election on April 15 of the previous tax year, which permits them to count the total of all their trading gains and losses as business property on part II of IRS form 4797.
Traders who make this election are also exempt from the wash sale rule, as mark-to-market accounting only concerns the total of a tax year’s profits and losses. However, beyond making the election in the previous tax year, traders who choose the mark-to-market accounting method must pretend to sell all of their holdings at their current market price on the last trading day of the year and pretend to purchase them again once trading resumes in the new year. This is entirely a paper transaction, but has to be done to provide a total accounting of the business assets each year.
Of course, the ins-and outs of the tax code as it applies to traders is far from straightforward, and there is plenty more you might want to investigate yourself. This guide should get you started on assessing what your taxation situation looks like now, and what it might look like in the future.