In today’s very tumultuous landscape day traders have to think about how they will report their gains and losses. Once exclusive to professional traders, day trading is now accessible to normal people due to online platforms such as Robinhood. This accessibility increased in day trading. “Day traders” generally purchase assets and make trades multiple times daily to sell at a higher price than bought. Understanding the tax filing options available for individuals participating in day trading and treating it as a business is essential.
Qualification As A Trader
For tax purposes, the qualification as a trader in securities is determined by engaging in substantial, regular trading activity. This includes frequent trading to profit from short-term market movements. The IRS typically looks for consistent trading patterns, significant hours dedicated to trading, and a focus on trading as the trader’s primary business rather than as a hobby or secondary activity. The IRS has denied trader status to people who made 1100 trades but made 86% of those trades in only two months of the year. Those who don’t meet these criteria are considered investors, and their trading is not treated as a business. This distinction is crucial for individuals interested in day trading, particularly those familiar with the significant tax implications of trading.
Mark-To-Market Election
A day trader who wants different tax treatment should opt for the Section 475(f) election. Opting for the Section 475(f) mark-to-market election primarily affects the tax treatment of gains and losses. By choosing this election, day traders can treat all their trading gains or losses as ordinary income or losses, bypassing capital gains tax rules and the limitations on deducting capital losses. This can lead to tax advantages, especially for traders who frequently incur losses or have a relatively high level of trading volume, since they will no longer be subject to the capital loss limitations.
A day trader that opts for the Section 475(f) mark-to-market election will treat all trading as ordinary gains or losses on Form 4797, Sales of Business Property. Additionally, at the end of the year, the securities held by the day trader are marked to market, meaning they are treated as if they were sold at their fair market value. To make this election, the trader must submit a statement that includes:
- A declaration that an election under Sec. 475(f) is being made
- The tax year when the election will take effect; and
- The trade or business for which the election is being made (Rev. Proc. 2018-31 and IRS Topic No. 429).
A day trader who makes this election must also change their accounting method for securities by Rev. Proc. 2019-43, which involves filing Form 3115, Application for Change in Accounting Method. Once the mark-to-market accounting method is adopted, the limitations on capital losses and the wash-sale rules no longer apply.
The election must be submitted by the original due date without extensions. If a day trader misses the original due date for submitting the mark-to-market election, they cannot file for the election for that tax year, as the IRS requires it to be submitted by the original due date without extensions. However, they may continue trading as usual, and in the following tax year, they can make the election, ensuring they meet all filing requirements and timelines for the new tax year.
Business Expense Deductions Availability
Further, a day trader recognized as a securities trader can deduct expenses related to their trading activities as business expenses since these activities are regarded as a business. Deductible expenses include costs for equipment such as computers or monitors, trading software, educational courses about trading strategies, and potentially a home office deduction. These expenses should be reported on Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship). However, commissions and other costs related to buying or selling securities are not deductible; they must be factored into calculating gain or loss when the securities are disposed of.
Capital Gains And Losses Treatment
When a day trader who qualifies as a securities trader has not opted for the Sec. 475(f) election, the profits and losses from their securities transactions are classified as capital gains and losses. Transactions that produce long-term capital gains benefit from preferential tax rates. However, the limitations on capital losses stipulated in Sec. 1211(b) and the wash-sale rules in Sec. 1091 also apply to the day trader. The trader must report these securities transactions on Schedule D, Capital Gains and Losses, and on Form 8949, Sales and Other Dispositions of Capital Assets, as necessary. Even though a day trader engaged in securities trading is considered to be conducting a business, they are not required to pay self-employment tax on the profits and losses from their securities transactions.
In conclusion, day trading has become increasingly accessible, allowing more individuals to engage in this fast-paced trading style. Understanding the tax implications and options available, such as qualifying as a trader for tax purposes and considering the mark-to-market election, is vital for those looking to treat their trading activities as a business. By staying informed about deductions and the proper reporting of gains and losses, day traders can optimize their tax situations and navigate the complexities of this endeavor effectively. With thorough preparation and adherence to IRS guidelines, day traders can leverage their activities to enhance their financial outcomes while minimizing potential tax burdens.
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