Just like any other financial realm, the stock market too comes with its fair share of compliance on taxes. Whether you are just a casual investor or a busy trader, the implications of your stock purchases and sales will fall within the ambit of the US tax laws. Given the larger volumes and the complexities involved, day trading demands more attention on the taxation front.
There is no doubt that taxation laws can be extremely nebulous and obscure. Getting to understand these and ensuring compliance is not easy for even regular investors. There are important points to know and consider about trading taxes and the implications for non-adherence. We will try and demystify the various tax requirements and help you understand how to go about filing your returns correctly.
Difference between Investors and Traders for Taxes
The tax implications for traders and investors are different as are the definitions for these two types of market players. While they both buy and sell stocks, unlike the trader, the investor is not deemed to be in the business of trading in the stock market. The treatment of taxation at the hands of the IRS, therefore, is different for both.
Investors and investing from taxation standpoint
To understand how taxes impact an investor, you need to understand what he does.
By definition, an investor in the stock market is someone who takes a position in a particular stock by purchasing it outright, looking at the value proposition it offers over a prolonged period of holding.
Anyone who buys stocks could, theoretically, hold them for anything ranging from a few seconds to years together. The upside or downside he makes on the sale of his asset is based on the duration held. So are the applicable taxes that have a bearing on the period held for before a subsequent sale.
Capital gains – short term and long term
If the investor purchases and holds a stock for less than one year before selling it, the profits made will be considered short-term capital gains. Similarly, the profit made from selling a stock that was held for over one year from the date of purchase is deemed as long term capital gains.
Capital losses – short term and long term
Similarly, the converse is also applicable. That is, selling a stock at a loss after holding it for less than one year is treated as short term capital losses while a sale after one year of purchase is deemed as long term capital losses.
Typically, from a taxation standpoint, an investor’s tax liability on the appreciation he makes is two fold. There is the profit on the invested capital for the period held. There is also the benefit of periodic returns, from the stock held, in the form of dividends and interest.
You can lower your taxes by holding onto investments for at least a year.
Traders and trading from a taxation standpoint
The trader is in the business of buying and selling stocks and his returns are in the form of gains made through these trades. A day trader can perform several such trades during a session and seeks to take advantage of the market volatility and price fluctuations to make profits. So, the time spent trading, the volume of trades and the turnover are key criteria that define a trader.
As against an investor, the differentiating aspect here is the preference for doing business to get short term gains instead of long term appreciation.
Classification of traders
Beyond the definition, how are traders classified under the tax laws? This can be an important point to understand for anyone, especially a trader, because the tax liability on a trader is much less than that of an investor. So, to get your classification correct and, therefore, to get the benefits due for your rightful category, it helps to clear any confusion here.
As a trader, there are three broad criteria that you need to meet. These emerge from a landmark tax case that has come to be known as Endicott vs. Commissioner. The observations thrown up from this case have been seminal in the classification between a trader and an investor.
Endicott vs. Commissioner
This case was about Thomas Endicott, a retired American executive, who picked up trading as a post-retirement occupation and began buying, and selling stocks and call options. While he did not trade stocks every day of the week, Endicott stuck to monitoring the market and reviewing his portfolio and transactions on a daily basis. His volumes in two years – 2006 and 2007 – were not very high but in 2008, it stood at a respectable 1500 plus trades. Also, while he held on to most stocks in his portfolio for well over one year, the average holding of the stocks he traded in were just over a month at 35 days.
When the IRS hauled him up for wrongly interpreting himself as a trader instead of an investor, this case went to court.
To sum up, the IRS observations on the Endicott vs. Commissioner Case were as follows:
- To qualify as a trader, an individual needs to be either a full-time trader and have this as his primary occupation. If not, he should still be utilising most of his working day, every day, to buy and sell stock.
- On each day the market is open, he should demonstrate consistently high numbers of trades.
- Finally, to differentiate a trader from an investor, he should be able to prove that his intention and goal is to gain from short term fluctuation of stock price and not profit from the sale of long term holdings.
In the light of the court’s findings, Endicott failed to claim trader status for the period being contested and had to face penalties thereof.
So, if you are an aspiring trader or already into trading but not a full time one yet, the inferences from this case needs to be studied and understood to avoid any potential run-ins with the IRS.
Tax benefits of being a trader
There is a clear benefit, from a tax perspective, for traders in the US. Because they are considered as self-employed, any expenses incurred as part of the trading business are eligible for deduction on Schedule C.
Always maintain a trail and receipts of what you spend as capital expenditure and operating expenses. You are spared any self-employment tax on the net profit you make. Of course, you can write-off in excess of only 2% of the adjusted gross income.
Applying the mark to market accounting methodology
For any trader, mark to market is an accounting tool that can work in his favour if used smartly. This methodology refers to traders being able to report their losses and gains as if they sold it all on the last day of the year. That is, this allows traders to pretend that they sell their entire holding on the last trading day of the year on that day’s rates. The next step here is to then repurchase them the very next day, on the first day of the New Year.
The advantage here is that it facilitates adjusting their net trading losses against other income. Ordinarily, there is an upper limit of $3000 that applies for investors. But as a trader, you do not have any limits. This helps traders start a new year afresh on a blank slate without any gains or losses carried forward.
Avail advantage of the wash sale rule in trading
A wash sale refers to a situation where a trader sells a stock at a loss only to buy it back in a short timespan that, as per the IRS laws, has been pegged at 30 days. The same or even a similar stock being repurchased by either the trader himself or a spouse or business partner qualifies as a wash sale.
This is a common enough strategy employed just before a year ends when a share is sold at a loss just to claim an overall loss for their tax return purposes. It helps lower the final payable tax amount for the year and also allows for a repurchase of the same or similar stock the next day, the first of the new year. The wash sale rule, however, allows only a day trader to avail of this benefit. Investors are not permitted to take advantage of this rule.
Reporting your taxes
As a trader, all capital gains and losses need to be done on Form 8949 and Schedule D. While Schedule C carries expenses, it’s Schedule D that shows the profits. If you incur any capital losses, you can deduct up to $3000 as an individual while under the married category, it is possible to file separately and limit this to $1500 each.
Scenarios
As mentioned above, there is this clear distinction between an investor and a trader and every player in the stock market needs to understand how this line is drawn. The IRS has spelt out the conditions that separate the two and, as we saw in the Endicott vs. Commissioner case, a wrong interpretation can land a person in trouble.
It is clear that the tax laws favour the trader and day traders have a few big advantages that can help them reap benefits from these clauses. Before you classify yourself as a trader, double check to make sure that your activities in the stock market tick all the boxes of a trader and does not leave you as an investor.
Here are two case scenarios to seal any doubts that may still persist.
Scenario 1: Mr A has been in the stock market and has averaged around 200-250 trades in the year and has sold off stocks within days of purchasing them. He can also prove he spends, say, 10 hours of trading in a week.
Scenario 2: Mr B has also been active in the market and has managed to average up to 1500 trades of a short term holding in a year, selling them off within a few days of buying them. He has put in a much longer duration of 20 hours of weekly trading.
From the standpoint of the IRS, Mr A has not spent time enough doing the trading function nor has he had the volumes to justify the trader tag in that year. But, going by both the time spent and the volumes of trades generated in the year, Mr B qualifies to be a trader.
Of course, a player in the stock market can be deemed to be an investor and a trader. As long as you can distinctly separate the two and keep the respective books apart and ensure your accounting proves that, you can wear the twin hats of an investor and a trader.
Some useful tax terminology
To navigate the often complex world of taxes, it helps to be familiar with some of the commonly used terminology. Here are a few of the jargon that is good to know.
Cost basis: This is the price at which you picked up a stock in a certain trade. The cost basis also includes the commission you had to pay on the purchase or sale. Using this amount as your baseline, you will be able to calculate your capital gains or losses for the days’ trading.
Capital gains: When you sell a stock at a price greater than what you bought it, you stand to make a profit, right? Likewise, you make money when you buy a stock cheaper than the price at which you sell it. This is the profit that qualifies as capital gains and, regardless of whether you are a trader or an investor you are required to pay tax on these amounts at rates applicable to you.
A gain accruing from a position held for under one year requires you to pay short term capital gains. If you have held the stock for over a year, any gain from that trade qualifies as long term capital gains. While short term capital gains are taxed at a higher rate of up to 35%, long term capital gains attract only 5 to 15% depending on the tax bracket you fall into.
Capital losses: The converse is applicable here for capital losses. That is if you were to sell a stock at less than what you bought it for or bought a stock at a higher price than you sold it short for.
For day traders, it is possible to adjust capital losses against the gains made over a financial year. There is also a provision of an additional $3000 over and above if your trading year ends up in losses. Any losses that exceed this can be carried forward to the next financial year.
Taxes specific to asset classes
Do all types of instruments you trade in attract the same rate of taxes? By and large, the IRS does not differentiate across most asset classes. For instance, there is not much difference between tax implications whether you are trading in stocks or in forex. But there still are some exceptions you need to be aware of.
A case in point is Futures. It is the 60/40 rule that is applicable here. Here is a sum-up of how taxes are applicable when trading in Futures.
40% of the gains will be treated as short-term and taxes applicable will be as per your respective income tax slab. But the difference is in the 60% where the taxable amount will be different for each bracket. These will be zero taxes for the 10 to 15% bracket while the 25 to 35% pays 15% and the 36.9% a higher 20%.
Tax preparation
Like any other investment, traders should be ready with their tax return preparations on or by April 15th every year. This means, as a stock trader, you need to prepare your financial statements and reports for the previous year and submit your tax returns by this date.
To make the tax preparation process stress-free, you need to do the following:
Keep a record: For accounting purposes, traders should maintain a separate account for trading and keep a record of the gains and losses on each trade. To receive maximum benefits without hassle, keep a record of the following information:
- Instrument
- Price
- Purchase and sale date
- Size
- Entry and exit point
Day trader software: Trading generates a lot of separate transactions and accounts to track, and the tax laws can be overwhelming for the average trader. So, how do you manage your taxes?
There are trading tax software that can project your annual trade history and gains and losses report with a single click. Day trader software comes with an extensive array of tools and features that can speed up the filing process and reduce the chances of errors. Tax preparation software integrates across all major exchanges and makes the process of submitting an accurate return effortlessly.
Tax preparation software is easy to use, makes your tax filing faster and is affordable. It also allows you to concentrate on trading, rather than spending late nights surrounded by complex IRS forms, heaps of transaction receipts and financial documents.
As a trader, you need to stay well-informed and updated about the market, its various risks and rewards, the latest tax-related news and how it affects your trading style and strategies. It is also necessary to understand the process of trading taxes in the US when it presents itself every financial year.
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