In January 2021, online day traders trapped institutional short sellers in a short squeeze by buying up shares of the video and computer game retailer GameStop. This episode brought attention to a number of issues including the distinction between securities traders vs. investors for federal income tax purposes. Traders are eligible for favorable federal income tax treatment for their short-term trading activities, compared to investors.
Tax Advantages of Trader Status
Potential upsides of qualifying for trader status for tax purposes include:
Traders can deduct expenses on Schedule C and benefit from SE tax exemption. They’re considered to be in the business of buying and selling stocks (and other securities, if applicable) for a profit. Therefore, traders can fully deduct trading-related expenses on Schedule C like any other sole proprietor. However, unlike most sole proprietors, they don’t have to pay self-employment (SE) tax on their net profit from trading.
Traders can make the “mark-to-market” election. Traders who make this election enjoy two important tax advantages. First, they don’t have to worry about the wash-sale rule, which defers a tax loss when the same stock is bought or sold within 30 days before or after a loss sale. The disallowed wash-sale loss gets added to the basis of the shares that caused the problem. But, with the mark-to-market election, a trader doesn’t have to spend any time on unproductive bookkeeping to comply with the wash-sale rule, freeing up time for researching and trading stocks.
Second, traders who make this election are exempt from the $3,000 annual limit on deducting net capital losses ($1,500 if you use married-filing-separate status). That’s because, as a mark-to-market trader, gains and losses from trading are considered ordinary gains and losses, like garden-variety business income and expenses. So, if a trader has a bad year, his or her net trading loss can be fully deducted, rather than being limited to $3,000 (or $1,500).
Mechanics of the Election
Traders who make the mark-to-market election must pretend to sell their entire trading portfolio at market prices on the last trading day of the year and include all the resulting tax gains and losses on their personal tax returns. If a trader has an overall gain, his or her tax bill goes up accordingly even though the shares haven’t actually been sold. This could create a liquidity issue for cash-strapped traders.
Next, mark-to-market traders must pretend to buy back everything that they pretended to sell at year end at the same price. So, stocks in their trading portfolio will start off the new year with tax basis equal to market value and no unrealized gains or losses. That’s the mark-to-market concept in action. However, if a trader empties out his or her trading portfolio at the end of the year, or nearly so, this mark-to-market drill is either not applicable or relatively inconsequential.
A trader can’t benefit from the preferential 15% or 20% federal income tax rates on net long-term capital gains for gains from stocks held in his or her trading portfolio. But this really isn’t a problem because a trader shouldn’t have anything but short-term investments in his or her portfolio. (See “Segregating Nontrading Investments,” at right.)
Making the mark-to-market election requires forethought. To make the election for the 2021 tax year, a trader needed to attach an election statement to his or her 2020 return filed by May 17, 2021, or to an extension request for his or her 2020 return filed by that date.
To make the election for the 2022 tax year, a trader needs to attach an election statement to his or her 2021 return filed by April 18, 2022, or to an extension request for his or her 2021 return filed by that date.
As a result, many traders won’t be able to take advantage of the mark-to-market rules until the 2022 tax year at the earliest. It’s also important to note that, traders who haven’t already made the mark-to-market election, will need to apply for an accounting method change on IRS Form 3115 for the year the election is to take effect.
For example, Sam qualified as a trader for 2021 and will again for 2022. She makes the mark-to-market election for her 2022 tax year when she files her 2021 federal income tax return on April 18, 2022. Sam must include Form 3115 with her 2022 tax return when she files it next year.
Segregate Nontrading Investments
A taxpayer can be both a securities trader and an investor at the same time. This dual classification allows long-term gains from the taxpayer’s nontrading portfolio to qualify for the favorable 15% or 20% federal income tax rate without diminishing the tax benefits available for his or her trading activity.
To qualify for this best-of-both-worlds position, the taxpayer’s records must clearly identify nontrading investments as such on the day they’re bought. Also, the IRS requires separate brokerage accounts for investment stocks and trading stocks if the trader invests and trades in the same issues. Maintaining separate accounts will also make things cleaner if the trader gets audited by the IRS.
We Can Help
Despite the inherent financial risks of being a securities trader, this status offers important benefits from a federal income tax perspective. Contact us or your tax professional to determine whether you qualify. If so, your advisor can help you make a timely mark-to-market election and properly report your trading gains, losses and expenses.