You know that most traders enjoy a six or seven-figure income, no boss and 30-hour work week. But a big truth about day traders is that they enjoy tax benefits as well. Day traders can keep a large part of their trading gains given the advantage of their tax situation.
Traders incur a lot of expenses. They subscribe to various newsletters, pay trading commissions, buy computer equipment, hire accountants, hold meetings with other traders to discuss ideas, pay for Internet connection and hire lawyers. Uncle Sam recognizes that. You just have to keep a record of all the expenses as you incur them. You can use a spreadsheet, notebook or a personal finance software for this purpose.
But you can’t enjoy the perks if you don’t know the nuances of the tax code. Here are the five tips for day traders to reduce their taxes.
Protecting The Trader Status
There is a blurred distinction between the definitions of trader and investor. In order to enjoy the tax benefits of a trader, you have to qualify as a trader first. Even people who trade 3-4 times a week are considered as investors by IRS.
IRS says you are a trader only if you buy and sell stocks almost every working day. You can be a part-time trader, and have a regular day job, but you should trade every day. You have to have a consistent pattern of making a number of trades. Your goal should be to make money from the short-term market swings, instead of long-term appreciation or dividend income.
In case you earn more at another job, or simply have another job, make sure to consult with a tax professional who is expert in Traders Accounting.
Reducing Your Taxes
If you have successfully qualified as a trader, you can deduct a number of expenses that an investor cannot. You can deduct all you trading related expenses on Schedule C. In contrast, investors can write off only the amount that exceeds 2% of their gross income and can’t deduct more than $3,000 in capital losses. As a trader, you can write off all your trading losses. Moreover, Schedule C deductions reduce your adjusted gross income, and now you can deduct your personal exemptions and take advantage of other tax benefits.
You can take an immediate write-off for equipment that you use more than 50% of the time in your trading activities like desk, bookshelves, computer, fax machine, etc. Plus you can deduct your margin account interest on Schedule C. If you work from home, you can also take a home office deduction, just make sure that the deduction doesn’t force you into a loss position.
Moreover, you are not required to pay self-employment tax on your profits as capital gains are exempted. Pretty good deal, eh?
Mark To Market Trading
Normally, IRS allows you to write off the losses when you sell a stock at a loss. But if you repurchase that stock within 30 days before or after selling it, it is considered as “wash sale”. IRS has implemented a 30-day wash sale rule where you can’t recognize a loss on a trade if you buy the same stock within 30 days.
So, what can you do? Simply become a “mark-to-market” trader and you’ll be exempted from the 30-day wash sale rule. It works something like this. On the year’s last working day, you sell all your stocks (only on records, not in reality). Though you still hold all those stocks, you book losses and gains (imaginary) as of that trading day just for tax purpose. You start the new year with absolutely zero unrealized gains or losses as if you have repurchased all the stocks you pretended to sell.
It has another benefit as well. Investors are usually allowed to deduct not more than $3,000 in net losses per year. But you, as a market-to-market trader, can write off any amount of losses. That’s a big relief, especially when the market is really awful.
Segregating Your Long-Term Investments
Did I tell you that you can be a trader and investor both at the same time? In that case, your long-term investments will still come under the umbrella of that nice 15% tax rate without affecting your trader tax benefits. Yes, you can get the best of both worlds.
To enjoy those benefits, you have to clarify your investment holdings on records the day you buy them. IRS requires you to keep trading and investing stocks in separate brokerage accounts, especially if you have invested and traded in the same stock.
State Income Taxes
When itemizing your tax deductions, you, as a trader, can also deduct state income taxes on your interest income which is exempt from the federal income tax. However, you can’t deduct state income taxes on other exempt income, either as investment expenses or taxes.
All the 50 states have different rules for taxing investment income. Make sure to check with a state-savvy tax advisor and the state revenue department.
Image Credits: niftyvidhata on Flickr