Are you a trader or an investor? This assuming that you do a number of financial transactions throughout the year.
The distinction can be significant for tax purposes.
Factors that separate traders and investors: Traders engage in frequent buying and selling, usually owning securities briefly; for just a few days or even only a few minutes for some day traders. Their trading activities are continuous, over the full year and not just for a couple of months.
And they look to make money on short-term swings in market prices. Investors earn profits mainly on long-term appreciation and dividends. They hold securities for longer periods of time and sell much less often than traders.
The capital gain tax break for investors is the 15% rate for most taxpayers on the gain from investments that are held for more than one year. Higher-income taxpayers can be hit with a 20% rate and the 3.8% Medicare surtax, while filers in the 10% or 15% income tax bracket enjoy a special 0% rate on profits.
Capital losses are capped. They can offset only capital gains plus up to $3,000 of other income, with any excess capital losses carried forward to future years. And deductions are limited.
Only itemizers can take investment-related costs, subject to the 2%-of-AGI offset. There are also hurdles when deducting margin interest.
Traders get important tax benefits: They can fully deduct their expenses on Schedule C. Having above-the-line write-offs is useful, especially for upper-incomers who may be subject to phaseouts of itemized deductions and personal exemptions. Additionally, net profits from trading are exempt from self-employment tax.
But their gains are mainly short-term and taxed at ordinary income rates. Losses incurred by traders are generally treated as short-term capital losses. But there’s a way they can fully deduct losses: Make a Section 475(f) election.
Traders who so elect must recognize gains and losses as if they’d sold their holdings for fair market value on the last day of the tax year. While the election is in effect, the deemed gains and losses are treated for tax purposes as ordinary income and loss. The election can only be made prospectively. An election for the current year is required to be done by the due date of the income tax return for the preceding year. Once made, the election continues for each year. It can’t be revoked unless IRS agrees.
The deadline to make an election for the 2016 tax year is April 18 for most.
If you want to elect and haven’t done so previously, you must attach a statement with your 2015 return or with your request for a filing extension. The Service doesn’t like to approve late 475(f) elections, so make sure your election is timely.
Lastly, claiming trading losses is an audit red flag. IRS pulls returns to check whether the taxpayer is a bona fide trader or an investor in disguise.
Caution must be used in making the distinction, we can assist in helping make the determination of “Investor” or “Trader”, give us a call.