Tax season doesn’t have to be daunting. This guide explains the deductions available for day traders compared to investors.
“...[I]n this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin’s cheeky quote is probably the most famous form of the phrase, but his letter to Jean-Baptiste Le Roy in 1789 was not the first use of the “death and taxes” idiom. Christopher Bullock’s 1716 farce, The Cobler of Preston, predates the founding father’s quote, when one of the characters quips:
“‘Tis impossible to be sure of any thing but Death and Taxes”
If people were complaining about taxes in the early 18th century, it seems like taxes have been inescapable long before there was even a United States government.
Today, filing your taxes in the U.S. can seem complicated. For those who earn any income that isn’t from a standard 9 to 5 job — such as day traders — tax season might feel even more overwhelming.
Yet just because taxes are unavoidable doesn’t mean they have to be difficult. Part of what can make taxes feel daunting is the variety of circumstances that affect how you file them. The type of investing you do, the amount of income you make, and even your marital status all impact your individual tax situation.
This overview breaks down how day traders can file their U.S. tax returns as well as the strategies that can help organize deductions. However, this informational article is only a basic guide, and consulting a professional tax advisor may help you evaluate your personal circumstances more effectively.
TAXES FOR DAY TRADERS VS. INVESTORS
The type of investing you do determines the way you file your taxes. With the Internal Revenue Service (IRS), investors and traders have varying tax rates based on how long they hold their assets. Many investors might day trade some securities in addition to their long-term investments, but for the purpose of this article, let’s focus on income generated from trading.
According to the IRS, if you seek to profit from daily price movements in securities, have “substantial” trading activity, and trade with “continuity and regularity,” you may qualify for trader tax status. While there are no concrete guidelines for what the IRS considers as “substantial,” part-time day traders who do not use trading for their primary income are unlikely to qualify.
The IRS classifies traders as self-employed individuals, meaning they can deduct all trading-related expenses on Schedule C (Form 1040) as sole proprietors. These might include:
- Internet, computer, and other devices used for trading
- Home office deduction
- Office supplies
- Interest expenses for margin loans
Commissions and other costs of acquiring or disposing of securities are not deductible, but they must be used to report gains or losses. The self-employment tax does not apply to your net profit from trading.
The IRS urges traders to keep detailed records throughout the year and evaluate the typical holding periods for the securities they buy and sell, the amount of trades during the year, and the amount of time they devote to it.
Normally, taxpayers can sell a stock at a loss and write off that amount. However, most investors must abide by the wash sale rule. This means they can’t sell or trade a security at a loss, and within 30 days before or after, buy a similar one. The wash sale rule prevents investors from deducting a capital loss on the sale against the capital gain.
On the other hand, day traders can choose to use the mark-to-market rules, which would make them exempt from the wash sale rule. First, a trader must elect to use mark-to-market rules by last year’s original due date — for example, if you’re filing for 2020’s tax return, you would have needed to make the mark-to-market election as of April 2020.
Next, the taxpayer needs to create some unique circumstances for the accounting purposes. Traders using mark-to-market rules must pretend to sell all holdings at their current market price on the last trading day of the year, then pretend to purchase them again once trading resumes in the new year. This method helps with accounting for all business assets for the year.
In addition to avoiding the wash sale rule, mark-to-market rules can benefit traders because they can deduct unlimited net trading losses against other income. Most investors have a limit of $3,000 that they can deduct in net capital losses per year.
Whether you consider filing taxes more advantageous as an investor or a day trader depends on your individual situation. The IRS aims to design rules and tax breaks for a range of investing styles, and ideally, what you owe Uncle Sam should reflect the ways you made your income last year.
And if April 15 is still intimidating for you, the good news is tax season only comes once a year. Just don’t forget to get a good tax adviser and keep your receipts!