Do I Qualify for Trader Status? A Look at the Tax Advantages and How You Can Get Them

Image courtesy FreeDigitalPhotos.net

Image courtesy FreeDigitalPhotos.net

By Jason Van Steenwyk

The good news is that if you are a full-time, obsessive-compulsive, dyed-in-the-wool, hardcore FOREX or other market trader, trading on a daily or near-daily basis, there are some significant tax advantages available to you that aren’t available to more casual market participants. The bad news is that it’s pretty tough to qualify for them. But we’ll get to that in a bit. Why would it be a good idea to qualify as a ‘trader’ for federal income tax purposes?

First of all, you get to deduct a lot more. If you’re a full-time trader, rather than a garden-variety do-it-yourself investor, you get to list your deductions on a Schedule C. Essentially, the IRS then recognizes all your trading expenses as business expenses. Everyone else has to use Schedule A. That difference right there can potentially save a trader a chunk of change when it comes time to file income taxes.

Here’s why:

 

The Schedule C Advantage

Normally individual investors have to deduct their trading and investment expenses on Schedule A of their individual income tax return. The IRS treats them as miscellaneous itemized deductions, and as such they are generally subject to a 2 percent of adjusted gross income threshold before they become tax deductible.

This means if an investor has an annual income of $100,000, and $5,000 of trading expenses, he can only deduct $3,000 (assuming no other miscellaneous itemized deductions).

A trader in the exact same situation, but who qualified for trader tax status, lists trading expenses on Schedule C, Profit or Loss from Business. Schedule C expenses aren’t subject to the 2 percent threshold that applies to miscellaneous itemized expenses, and therefore the trader would be able to deduct all $5,000.

The same deal applies to interest expense, if any. This is significant for forex and commodities traders, who are often highly leveraged and therefore may have significant interest expenses. Traders can deduct every penny of interest on their Schedule C, where individual investors must list investment interest expense as a miscellaneous itemized deduction on Schedule A. (Note: Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss.).

This became an even more significant issue beginning in 2013, as so-called “Pease limitations” restricted the amount of miscellaneous itemized deductions you could take if your income was over $250,000 (singles) or $300,000 (married filing jointly).

Furthermore, while investors can only deduct interest expense to the extent of investment income, traders have no such limit. If interest expenses exceed investment income, traders can deduct any amounts left over against ordinary income. This is true even if interest expenses exceed investment income by more than $3,000.

The Section 475 Mark-To-Market (MTM) Election

This is a significant tax advantage available to qualified traders that isn’t available to ordinary investors. The IRS allows those qualifying as traders to elect mark-to-market (MTM) accounting on securities and Section 1256 contracts. The rules are laid out in Section 475 of the Internal Revenue Code.

The rule lets you treat any covered security you hold (other than for inventory, which isn’t applicable to most individual traders) as though you sold it for its fair market value at the end of the year. So you don’t have to sell anything to recognize a taxable loss (or gain) for that matter. Gains are treated as ordinary income, and losses are treated as ordinary losses. Ordinary losses are better to have than capital losses, because you can use them to offset all types of income, including ordinary income, capital gains, interest and portfolio income and passive income.

In contrast, usually, any investor in a Section 1256 contract has to accept capital gains tax rules. That hurts, because if you have more than $3,000 in net losses after your gains are cancelled out, you can’t deduct the excess losses above the $3,000 mark against income. If you’re a trader, you can get around this limitation by making the Section 475 MTM election with the IRS (though you have to do so by April 15th. You can’t look back in time and make the election).

Tip. If you have a large 1st quarter loss, you may want to consider making this deduction to ensure that you can maximize your write-offs. Many advisors recommend it to the vast majority of their clients, because the downsides are few and far between, compared to the upsides of MTM election.

If you blow the election deadline, you can still form a new entity and trade through that, as long as you make your election within 2 months and 15 days of forming the entity.

Carryback of Losses

Got excess losses? Investors are out of luck on anything over $3,000, as we mentioned. They have to carry those losses forward and apply them in future years. But if you’re a trader, and you qualify for the MTM election, that election allows you to carry losses backwards in time, and get a refund from a limited number of prior tax years!

The Alternative Minimum Tax

If you are subject to the alternative minimum tax, most of your investment expenses get ‘clawed back,’ or disallowed under the AMT. That’s not true, however, if you qualify as a trader under IRS rules. Your expenses get treated as deductible business expenses under either set of tax rules.

Investors, as opposed to traders, have to list capital gains and losses on Schedule D.

Do I Qualify? 

While the tax advantages of trader status are significant, it’s not easy to qualify for them. According to the IRS,

  • 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; and
  • You must carry on the activity with continuity and regularity.

Obviously, Congress wrote in a lot of wiggle room, because each of these standards is very subjective. The law has never specifically defined terms like “substantial” and “with continuity and regularity,” nor has Congress offered traders much in the way of safe harbors. So where the statute doesn’t provide much guidance, we must look to actual enforcement actions, regulations and case law for guidance.

In a recent U.S. Tax Court case, Endicott v. Commissioner, the court specifically ruled that executing in trades 75 times in one year and 99 times in another was not sufficient to qualify as continuous and regular trading. This was despite the fact that Endicott did, in fact, devote substantial time to monitoring his investments on days in which he did not execute any trades.

Furthermore, the judge held buy-and-hold investing against him. Yes, it seems strange to think of someone who engages in 99 trades in a year as a ‘buy-and-hold’ investor. But the facts in the case led the judge to conclude that Endicott was looking to dividends and capital gains to generate his profits, rather than adhering to the IRS’s requirement that he depend on daily market movements.

Endicott’s average holding period per trade during the years covered by the dispute was 35 days, during which time Endicott collected $120,000 in dividends or more.

Furthermore, Endicott, a retired business owner, collected over $350,000 in consulting fees during the same period. With so much income from an outside source, the court held, Endicott as an individual could not be considered to be a full-time trader.

So what do you need to do?

Robert Green, CPA, an accountant who specializes in providing services for active traders, has laid out what he calls his “Golden Rules” for qualifying for trader status. Given the precedents established by case law and private letter rulings, Green suggests the following are the real criteria to establish oneself as a trader for tax purposes:

  • Trade full-time or part-time, all day, every day.
  • Minimum 4 hours per day, average, working your trading business.
  • No real lapses in activity. You trade all year long, like you’re working a full-time job.
  • Trade on 75 percent or more of available trading days.
  • You should be making 1,000 trades or more each year.
  • Most of your trades should be day or swing trades
  • Your demonstrated intent should be to make a living as a trader.
  • You have invested heavily in tools, education, software, etc.
  • You have a home office or dedicated office space outside the home.
  • Your account size should be big relative to your overall assets.

Furthermore, Green says, algorithmic trades don’t count. You have to be the one pulling the trigger.

In addition, your profit model should rely on buying and selling frequently at a profit. The more you rely on long-term holding, interest and dividend income, and capital gains you attempt to treat under capital gains tax rules, then the more questionable your status as a trader becomes.

For more specific information, see Green’s book, the Green Trader Tax Guide. 

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