Taxes: The Business of Running Your Trading Business

Taxes can be a drag. But they're necessary. And as a trader, there are some things you should know about taxes. Being aware of some important items at the start of the year can help make the process simpler and quicker.

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5 min read
Photo by Dan Saelinger

Key Takeaways

  • Know if you qualify as a trading business for tax purposes
  • Learn about mark-to-market, the 60/40 split, and wash sale rules 
  • Understand tax strategies you could apply to protect some of your options trading gains

Hey, trader: We’ve always known you were special, a unique breed. Did you know that in some cases, the IRS thinks you’re special too?

You know that no matter how you made your cash, Uncle Sam wants his slice. But sometimes it’s good to stand out. So, let’s consider a few special circumstances for traders your accountant might not be aware of.

For Starters ...

Chances are you know about income, capital gains, capital losses, and so-called “wash sales.” This will all be important later.

There are basically two major categories of income as far as the IRS is concerned: earned income, which includes salary and wages, and investment income, which includes the profit from trades in equities, options, and other asset classes.

Suppose your earned income for the year was $100,000 and your trading income was $30,000. You’d 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.

Now let’s say that instead of earning $30,000 from your trades, you lost $30,000. You can only deduct $3,000 of the losses against your earned income, leaving you with a taxable income of $97,000.

And then there’s the wash-sale rule. At its most basic, this rule prevents investors from taking an artificial loss as a means to lower their tax bill. But the fine print gets more complicated.

Ready to dive deeper? Let’s talk taxes.

The Trader’s Election and Mark-to-Market

Want to balance out capital gains and losses? You can, but only if you satisfy exact IRS criteria. Here’s what the guidelines say:

Special rules apply if you’re 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:

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
  • Your activity must be substantial.
  • You must carry on the activity with continuity and regularity.

How do you know if you qualify as a “trading business”? Again, the IRS spells out the criteria:

  • Typical holding periods for securities bought and sold.
  • The frequency and dollar amount of your trades during the year.
  • The extent to which you pursue the activity to produce income for a livelihood.
  • The amount of time you devote to the activity.

If your trading activities don’t meet the definition of a business, you’re considered an investor, not a trader. It doesn’t matter whether you call yourself a trader (or a day trader).

But if you’ve determined you’re indeed “special,” taking the trader election allows you to mark-to-market (an accounting method that uses prevailing market price to determine value). So, using the earlier example, if you have $100,000 in earnings and $30,000 in losses, you can net them together. But take note: The $70,000 would be treated as ordinary income.

In a word, plan ahead for the trader election. For the coming tax year, set your status when you file the previous year’s taxes. If you want to apply, this is the time (for you and/or a tax-planning professional) to start the application process.

thinkorswim® Tax Tools

TD Ameritrade clients have access to GainsKeeper on tdameritrade.com (after logging in to your account, go to My Account > Tax Center).

GainsKeeper can help you figure out the tax consequences for any trade. On the thinkorswim platform, you can export transactions in a .TXF (tax exchange format) file, which you can use with compatible tax preparation software. Use the path Monitor > Account Statement. Select the actions menu on the right, then Export to file... and upload the data.

Here’s how you could use the transactions info:

  1. Find positions that were carried over from the previous tax year and not marked-to-market. Enter the date acquired and the cost basis for long positions, or enter the date sold and sales proceeds for short positions. If any fields need editing, there’ll be a prompt.
  2. Remove positions held over until the next tax year.
  3. Find positions that should be marked-to-market and move them into a separate file to add to your 1040 Form 6781.
  4. Find missing data and edit as needed.
  5. Enter matched records into your Schedule D. Enter the appropriate mark-to-market index trades in Form 6781.

That 60/40 Split

Have you traded futures, foreign exchange, index options, or other products that are marked to market? If so, you’ll need to file Form 6781, Gains and Losses from Section 1256 Contracts and Straddles.

Here’s a shocker for this time of year: This requirement can be considered good news.

Section 1256 contracts get special tax treatment of 60/40. So, positions held for any amount of time will receive 60% long-term capital gains treatment and 40% short-term capital gains treatment.

As an example, if you held a futures contract for three days and had a net gain of $1,000, $600 would be taxed at the long-term capital gains rate, and $400 would be taxed as ordinary income, which is often a higher rate.

This “preferential” tax treatment doesn’t stop there.

Section 1256 contracts are not subject to the same wash-sale rules as equities. Likewise, net gains and losses are carried over to Schedule D. If there’s a loss on 1256 contracts, they can be carried back, that is, they can offset the current or previous year’s gains.

Those Pesky Wash Sales

A wash sale is when you sell a security a ta loss and repurchase the same, or nearly identical, investment soon afterward. If you sell a stock or option for a loss, then buy the same stock or options on the same underlying stock within a 61-day window (30 days before or after the closing transaction), you can’t use the loss on your original sale against your taxes. The loss is added to the cost basis of the replacement shares, deferring the loss until those shares are later sold. The holding period for the replacement shares will also be adjusted to include the holding period of the shares sold for a disallowed loss.

Remember: The IRS considers all your accounts as one entity. So, if you have accounts at two different brokerages, you can’t sell for a loss in one account and buy the shares back in another. (Well, you can, but you won’t be able to deduct the loss.)

Do You Trade Options?

Here are four tax strategies you could apply to help protect some gains from options trading.

LEAPS®

Trading Long-term Equity AnticiPation Securities (LEAPS)—options contracts that expire up to two years and eight months in the future—can offer a tax advantage compared to buying and selling short-term options contracts. Of course, the position’s holding period dictates the tax treatment. If you use LEAPS to diversify a longer-term portfolio and hold the position for more than 365 days, any profits will be treated as a long-term gain and taxed accordingly.

Index Options as a Hedge

As mentioned earlier, using Section 1256 contracts—including options on the S&P 500 Index (SPX), Nasdaq-100 (NDX), and other broad-based indices—can give you preferential tax treatment. This can come in handy if, for example, you’re looking to hedge portfolio exposure without triggering a tax event. The same goes for futures contracts.

Buying Put Options to Offset Gains

If your large stock position shows a substantial gain but you don’t want to pocket the profit because of short-term tax consequences, you might buy stock puts to hedge the gains in the underlying. But there are risks. If the stock continues to march higher, your puts will likely lose. An option that’s out of the money (OTM) at expiration will result in a loss of the entire premium (plus transaction costs). And long options tend to decay, so that “theta” meter is working against you for as long as you hold the option.

To help with theta risk, consider buying in-the-money options, because they’ll have some intrinsic value and not all “time” value, initially. Of course, they can still expire worthless if they’re OTM at expiration.

Trade in an IRA

That’s right. Trading in a self-directed retirement account, like an Individual Retirement Account (IRA), can come with benefits at tax time. Investors are only taxed when a distribution is made, so the wash sale in the traditional sense doesn’t apply. However, transactions in an IRA can cause a wash sale in a taxable account. Say what? That’s right, the IRS will look at the holdings in both accounts to determine if the wash-sale rule was violated in the taxable account. Brokerages vary on rules for trading within retirement accounts, so do your homework. And some don’t allow options in IRAs, while others limit options trading to specific strategies.

Filing taxes doesn’t have to be like trying to find your way in the dark. Now that you’re aware of what to focus on before filing your taxes, the entire process maybe come more organized and streamlined.

Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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Key Takeaways

  • Know if you qualify as a trading business for tax purposes
  • Learn about mark-to-market, the 60/40 split, and wash sale rules 
  • Understand tax strategies you could apply to protect some of your options trading gains

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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.

Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

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