| The tax rules for stock investors in general requires | | | | long-term capital gains tax rates (currently 15%). |
| three steps. Step one is the netting of short-term | | | | Traders are also eligible for certain deductions that |
| capital gains and short-term capital losses. Step two is | | | | are not available to investors. One such deduction is |
| the netting of long-term capital gains and long-term | | | | the home office deduction. Traders may use their |
| capital losses. Step three is the netting of net short | | | | net income from trading activities to fund a SEP-IRA, |
| term gains/losses and net long-term gains/losses. Any | | | | and thus further reduce their taxable income. Another |
| capital losses in excess of $3,000 are carried forward | | | | such deduction available only to traders is interest |
| indefinitely to offset future capital gains plus $3,000 | | | | expense. Investors are limited to deducting interest |
| of ordinary income every year, until the capital losses | | | | expense incurred on debt used to finance their |
| are used up. But what if you are a "day trader"? | | | | investment activities to investment income (gains, |
| What special tax rules exist for day traders? This | | | | dividends and interest income). This limit on deducting |
| article will address those unique tax rules that apply | | | | interest expense to the extent of investment |
| to day traders. | | | | income, is not applicable to traders. Traders may |
| What is a day trader? In general, a day trader, is | | | | deduct their interest expense as a deduction on |
| anyone who engages in the business of trading | | | | Schedule C. Lastly, wash sale rules, which apply to |
| stock. You are in the business of trading stock, and | | | | investors, do not apply to traders. The wash sale |
| thus not an ordinary stock investor, when the | | | | rules require the deferral of trading losses, where the |
| frequency of your trading activity is such that it | | | | investor acquires substantially identical stock or |
| meets the "material participation" test. Qualifying as a | | | | securities within thirty days before or after a sale |
| trader under this material participation test is difficult | | | | generating a loss. |
| because one must be active in the securities markets | | | | So how do you make the leap once you have |
| on a daily basis and attempt to profit from | | | | determined that you are in the business of trading? |
| short-term swings in security prices. Many online | | | | Traders who desire to be treated at in the business |
| investors fail this test, but some day traders (most | | | | of trading stocks make an election called the |
| of whom are also online investors) meet the | | | | Mark-To-Market election by April15th of the current |
| standard. InPurvis [37 AFTR2d 76-968, 530 F2d 1332 | | | | year. To be treated as a trader for 2010, a trader |
| (1976, CA-9)], the Ninth Circuit Court of Appeals | | | | must make this election by April 15th, 2010, which is |
| upheld a prior tax court decision [Purvis, TC Memo | | | | attached to either their 2009 Form 1040 or attached |
| 1974-164 (1974)] and agreed with the Tax Court that | | | | to their 2009 extension. |
| in order to be classified as trading, the activity should | | | | Election language: |
| be performed with sufficient frequency to "catch the | | | | Taxpayer hereby elects under IRC Sec. 475(f) to use |
| swings in the daily market movements and profit | | | | the mark-to-market method of accounting for |
| thereby on a short-term basis." Day traders can take | | | | securities. This election will first be effective for the |
| a buy-and-hold approach, but most of them seek to | | | | tax year ended December 31, 2010. The election is |
| take advantage of short-term market fluctuations | | | | made for the following trades (list trades). |
| and this short-term market fluctuation criteria is the | | | | Once this election is made it is effective for all future |
| linchpin in qualifying some day traders as traders | | | | tax years. The mark-to-market election requires |
| rather than investors for federal income tax | | | | traders to mark their stock holdings to market value |
| purposes. | | | | at the end of the tax year. Once made, all security |
| What's so important about being considered a trader | | | | gains and losses are treated as ordinary income or |
| verses an investor? | | | | losses and all trading securities on hand at the end of |
| Investor losses in excess of $3,000 a year are not | | | | the year are deemed to be sold (and repurchased) |
| deductible in the year of the loss. This excess loss | | | | at the year-end market value. All unrealized (unsold |
| amount must be carried forward. There is no time | | | | securities) gains and losses recognized under the |
| limit on the future utilization of the excess losses, but | | | | mark-to-market election increase (unrealized losses) |
| if you continue to rack up losses each year, you will | | | | or decrease (unrealized gains) their basis in a given |
| be limited, each year, to this $3,000 loss limitation. | | | | security. |
| Traders, on the other hand, are not limited to this | | | | Because making the mark-to-market election can |
| $3,000 annual loss limitation. They are able to deduct | | | | have significant tax ramifications to future trading |
| their entire net loss for the year on their individual | | | | activities you should first consult with your CPA to |
| income tax return. Traders report their net gains | | | | determine if your trading activities meet the material |
| losses on Form 4797 as ordinary income (investors | | | | participation test and, if so, if this election makes the |
| report their net gains/losses on Schedule D. Net | | | | most sense to your future trading business. |
| long-term capital gains are taxed at the favorable | | | | |