Be aware of special tax rules such as gains, losses, and mark-to-market rules for traders and those who invest in certain derivatives.
If you’re a trader you take calculated and managed risks in an attempt to make money … or at least outperform your chosen benchmark. You might even do it for a living.
Well, the IRS has special tax rules—rules that you not only need to be aware of, but that might even benefit you financially depending on your level of trading activity. First, though, let’s get a baseline on how the IRS treats stock transactions for typical investors.
There are basically two major categories of income as far as the IRS is concerned: (1) earned income, which includes salary and wages, and (2) investment income, which includes the profit from trades in equities, options, and various other asset classes. The IRS doesn’t see the two as apples and apples. For taxpayers, it may even feel sometimes that the rules are written in a “heads they win, tails they win” sort of way.
For example, if your earned income for the year was $50,000 and your trading income was $20,000, you would be taxed at the prevailing marginal tax rate on your earned income and at the capital gains rate—either short-term or long-term, depending on how long you held your positions—on your trading income.
However, let’s say that instead of a trading profit for the year, you had a loss of $20,000. In that case, you could only deduct $3,000 of the losses against your earned income, leaving you with a taxable income of $47,000. Apples and overripe oranges.
For the average trader, a taxable event occurs only when you sell a position, but if you trade derivatives, you might need to be familiar with Section 1256 of the IRS tax code and how it applies to your trading.
Section 1256 requires that all futures, options on futures, and broad-based index options, such as SPX, be treated with “mark to market” status. This means that even if you didn’t liquidate a position by the last trading day of the year, the IRS treats it as if you did, and uses the closing price of that final trading day to figure your unrealized gain or loss. The closing price is “marked” and used as the cost basis going forward.
In addition, the profit and loss from these contracts is split into two groups for capital gains purposes, with 60% considered long-term capital gains and 40% short-term capital gains. This capital gains split is used regardless of how long you held the position. The following example from IRS Publication 550 shows how it works in practice:
On June 17, 2014, you bought a regulated futures contract for $50,000. On December 31, 2014 (the last business day of your tax year), the fair market value of the contract was $57,000 (this is the "marked" price). You recognized a $7,000 gain on your 2014 tax return, treated as 60% long-term and 40% short-term capital gain. On February 3, 2015, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2014 return, you recognize a $1,000 loss ($57,000—$56,000) on your 2015 tax return, treated as 60% long-term and 40% short-term capital loss.
There is a scenario in which traders can take advantage of some favorable IRS taxation rules. However, you must first take the “trader’s election”—essentially declaring that you are a full-time trader. This declaration should not be taken lightly, and you should carefully review the IRS criteria first to see if you qualify.
From the IRS:
Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.
The following facts and circumstances should be considered in determining if your activity is a securities trading business.
If your trading activities do not meet the above definition of a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader.”
If you qualify for the trader’s election, there are a number of differences, the first of which is the ability to choose the “mark to market” election—the same used in rule 1256. That means that on December 31, all your positions are considered closed, and the cost basis is based on the closing price on the last trading day. This election also exempts you from the “wash sale” rule.
In addition, the trader’s election allows you to write off all your trading losses against your profits, instead of the standard $3,000 max. That can significantly bring down your taxable income. And you can even expense certain costs against your profits, like the fees paid for software, subscriptions, data feeds, and educational tools.
But if you think you might want to take this election, don’t wait. The IRS requires that you file the election at the same time as you file your income tax return. So, if you want it to be in effect for 2017, you must file Form 3115 (Application for Change in Accounting Method) with your 2016 returns by April 18. The same applies if you want to revoke your election; it must be filed by the original due date of the return (without regard to extensions) for the taxable year preceding the year of change. Late revocations won't generally be allowed except in unusual and compelling circumstances. So you’ll want to have a discussion with your tax advisor to make sure the Mark to Market Election is the right step for you and your personal circumstances.
The Tax Resources page is chock full of tax calculators, guides, an archive of relevant content, and a link to IRS and tax forms.
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