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Trading Taxes in the US

Trading taxes in the US are determined by the Internal Revenue Service (IRS). The IRS considers several factors, including whether an individual is in the ‘business’ or ‘trade’ of selling securities.

This article will explain tax laws, rules, and implications for US traders. It will cover asset-specific stipulations, before concluding with preparation tips, including integrated tax software available at online brokers.

Last Updated: April 16 2024

Key Takeaways

• The Internal Revenue Service (IRS) is responsible for administering and collecting federal tax in the United States, including from online trading.
• The IRS will determine an individual’s tax status based on their classification as either a ‘trader’ or ‘investor’.
• US tax rates are arguably more favorable towards day traders, since trading-related expenses can be deducted, among other benefits.
• Day traders can also be exempted from the ‘wash sale’ rule, under the ‘mark-to-market’ rule.

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Investor vs Trader

Intraday income tax will depend on which category you fall into, ‘trader’ or ‘investor’. Unfortunately, determining this is complex and often done on a case-by-case basis.

As such, strict guidelines are set out in the 70,000 page long tax code, which also considers decisions in relevant case law.

Investor

Those that do not qualify as a ‘trader’ will likely be seen as an investor in the eyes of the IRS. This comes with a less advantageous day trading tax rate in the US.

Investors will have to account for gains and losses on form 8949 and Schedule D. Expenses will fall under the category of “miscellaneous itemized deductions.”

As a result, investors are unable to claim a home-office deduction and they must depreciate equipment over several years, instead of doing it all in one go.

Also, on Schedule A, investment expenses are combined with other miscellaneous items, such as costs incurred in tax preparation. Investors can also normally only write off the amount that exceeds 2% of their adjusted gross income.

Classification

Investors, like traders, purchase and sell securities. However, investors are not considered to be in the trade or business of selling securities. Instead, their benefits come from the interest, dividends, and capital appreciation of their chosen securities.

The key difference between whether you are entitled to page 1 deductions, as opposed to Schedule A deductions against income, rests on whether you’re in the ‘trade’ or ‘business’ of selling securities.

The bad news is that ‘trade’ or ‘business’ are not clearly defined. Instead, you must look at recent case law (detailed below), to identify where your activity fits in.

Trader

Those who spend their days buying and selling assets are probably going to fall under the ‘trader’ umbrella.

Classification

Day trading tax laws and recent cases tell us you’re a ‘trader’ if you meet the requirements tested in Endicott vs Commissioner, TC Memo 2013-199. The two considerations were as follows:

1. The individual’s trading was substantial.

And,

2. The individual aimed to catch and profit from the price fluctuations in the daily market movements, rather than profiting from longer-term investments.

In this case, the taxpayer’s primary strategy was to purchase shares of stocks and then sell call options on the underlying stocks. His aim was to profit from the premiums received from selling call options against the correlating quantity of underlying stock that he held.

He usually sold call options that held an expiry term of between one to five months. Endicott hoped the options would expire, allowing for the total amount of the premium received to be profit. He was not trading options on a daily basis, as a result of the high commission costs that come with selling and purchasing call options.

Endicott then deducted his trading related expenses on Schedule C. This reduced his adjusted gross income. However, the IRS disagreed with the deductions and instead moved them to Schedule A. They insisted Endicott was an investor, not a trader.

Number Of Trades

One of the first things the tax court looked at when considering the criteria outlined above, was how many trades the taxpayer executed a year. They also looked at the total amount of money involved in those trades, as well as the number of days in the year that trades were executed.

Endicott made 204 trades in 2006 and 303 in 2007. Then in 2008, he made 1,543 trades. The court decided that the number of trades was not substantial in 2006 and 2007, but that it was in 2008.

Amount Of Money

In 2006 Endicott made purchases and sales that totaled around $7 million. In 2007, the total was close to $15 million, and in 2008 it was approximately $16 million. The court agreed these amounts were considerable. However, they also stated, “managing a large amount of money is not conclusive as to whether a petitioner’s trading activity amounted to a trade or business.”

Key Points

From this case and other recent tax rulings in the US, a clearer picture of what is needed to satisfy the definition of ‘trader’ is appearing. The most essential of which are as follows:

• You spend a substantial amount of time trading. Ideally, this will be your full-time occupation. If you are a part-time trader, you need to be buying and selling several assets pretty much every day.
• You can demonstrate a regular pattern of making a high number of trades, ideally almost every day the market is open.
• Your aim is to profit from short-term price fluctuations, rather than long-term gains.

‘Trader’ Benefits

The US day trading tax rate looks favorably on the ‘trader’. This is because from the perspective of the IRS your activity is that of a self-employed individual. This allows you to deduct all your trade-related expenses on Schedule C.

This includes any home and office equipment, plus educational resources, phone bills and a range of other costs. However, it is important to keep receipts for any items, as the IRS may request evidence to prove they are used solely for trade purposes.

Nonetheless, traders can write off just the amount that exceeds 2% of your adjusted gross income. Schedule C write-offs will also adjust your gross income, increasing the chances you can fully deduct all your personal exemptions, plus take advantage of other tax breaks that are phased out for higher adjusted gross income levels.

In addition, you can often deduct your margin account interest on Schedule C. And you don’t have to pay self-employment tax on your net profit from trading.

Mark-To-Market Traders

There is another advantage and that centers around day trader tax write-offs. Normally, selling an asset at a loss allows you to write off that amount. However, if a trader, their spouse, or a company they control buys the same stock within 30 days, the IRS deem this a ‘wash sale’ (further details below).

This challenge can be avoided if the trader becomes a ‘mark-to-market’ trader. This will see them automatically exempt from the wash-sale rule.

On the last trading day of the year, the trader would effectively sell all holdings. They still hold those assets, but they book all the supposed gains and losses for that day. They would then enter the new year with zero unrealized gains or losses. It would appear as if they had just re-purchased all the assets they supposedly sold.

This brings with it another advantage, in terms of taxes on day trading profits. Usually, investors can deduct just $3,000 or $1,500 in net capital losses each year. Mark-to-market traders, however, can deduct an unlimited number of losses.

If you do qualify as a mark-to-market trader, you should report your gains and losses on part II of IRS form 4797. For further clarification, see IRS Revenue Procedure 99-17 in Internal Revenue Bulletin 99-7.

Wash-Sale Rule

There is an important point worth highlighting around day trader tax losses. In particular, the ‘wash-sale’ rule. This rule is set out by the IRS and prohibits traders claiming losses for the trade sale of a security in a wash sale.

A wash sale takes place when you trade a security at a loss, and then within thirty days either side of the sale, you, a partner, or a spouse purchase a ‘substantially identical’ instrument. If the IRS refuses the loss as a result of the rule, you will have to add the loss to the cost of the new security. This would then become the cost basis for the new security.

For further guidance on this rule and other important US trading regulations and stipulations, see our guide to trading rules.

Application

If you are a trader, you will report your gains and losses on form 8949 and Schedule D. You can deduct only $3,000 in net capital losses each year. However, if you’re married and use separate filing status then it’s $1,500.

Schedule C should then have just expenses and zero income, whilst your trading profits are reflected on Schedule D. To prevent any confusion, it’s a useful tax tip to include a statement detailing your situation.

Examples

Whilst it isn’t crystal clear, below are typical scenarios to help you see where your activity may fit in.

• Example 1 – Let’s say you spend 8-10 hours trading a week and you average around 250 sales a year, all within a few days of your purchase. The IRS is likely to say you don’t spend enough time trading to satisfy the ‘trader’ criteria.
• Example 2 – Let’s say you spend around 20 hours a week trading and you average around 1,250 short-term trades in a single year. The IRS should permit your takings as a day ‘trader’ on your tax return.

It is also worth bearing in mind that it is possible to be both a ‘trader’ and ‘investor’. If this were the case, traders should separate long-term holdings and keep detailed records to distinguish between both sets of activities.

Tax Terminology

A few terms that will frequently crop up when dealing with trading tax in the USA are:

Cost Basis

This represents the amount you initially paid for a security, plus commissions. It acts as a baseline figure from where taxes on day trading profits and losses are calculated. If you close out your position above or below your cost basis, you will create either a capital gain or loss.

Capital Gains

A capital gain is simply when you generate a profit from selling a security for more money than you originally paid for it, or if you buy a security for less money than you received when selling it short. Both traders and investors can pay tax on capital gains.

Normally, if you hold your position for less than one year it will be considered a short-term capital gain, and you will be taxed at the usual rate. However, if you hold the position for over a year you can benefit from a lower tax percentage rate, often around 15%. Although, depending on your income, it could also drop to just 5%.

Capital Losses

A capital loss is when you incur a loss when selling a security for less than you paid for it, or if you buy a security for more money than you received when selling it short.

Typically, for the purposes of taxes for day trading, you can write off (deduct) capital losses, up to the number of capital gains earned this year.

If you suffer more losses than gains in a year, you could write off an additional $3,000 on top of your offsetting gains. If your losses exceed the additional $3,000, you then have the option to carry those losses forward to the next tax year where you would have another $3,000 deduction allowance.

Asset Specific Taxes

With vast differences between instruments, many rightly question whether there are different tax stipulations you need to be aware of if you are trading in a variety of instruments. However, on the whole, the IRS is more concerned with why and how you are trading, than what it is you’re trading.

Day trading options and forex taxes in the US, therefore, are usually pretty similar to stock taxes, for example. Having said that, there remain some asset specific rules to take note of.

Futures

Gains and losses under futures taxes follow the ’60/40’ rule. The rate that you will pay on your gains will depend on your income. 60% of the gain is treated as a long-term capital gain at a rate of 0% if you fall in the 10-15% tax bracket. If you fall into the 25-35% tax bracket, it will be 15%, and it will be 20% if you fall into the 36.9% tax bracket. The 40% of the gains are considered to be short-term and will be taxed at your usual income tax rate.

So, on the whole, forex trading tax implications in the US will be the same as share trading taxes, and most other instruments. Whilst futures options can come with some interesting stipulations, the primary concern for all instruments is around ‘trader’ vs ‘investor’ status.

Tax Preparation

Keep A Record

To avoid any last-minute confusion or hassle, it is important to keep a record of the following:

• Instrument
• Price
• Purchase & sale date
• Size
• Entry & exit point

Having this information to hand will make taxes on trading US stocks a stress-free procedure.

Day Trader Tax Software

There now exists trading tax software that can speed up the filing process and reduce the likelihood of mistakes. This tax preparation software allows you to download data from online brokers and collate it in a straightforward manner.

Forex.com, for example, offers a Performance Analytics tool which assesses the past 12 months of your trading data, including P&L figures.

Final Word

Taxes on income will vary depending on whether you are classed as a ‘trader’ or ‘investor’ in the eyes of the IRS. Unfortunately, few qualify as traders and receive the benefits that brings.

Traders should be warned that the consequences of failing to pay the correct amount, or late payments, can result in severe ramifications.

Note this page is not attempting to offer tax advice. It aims to unpack the various stipulations surrounding intraday income tax. If you remain unsure or have any queries about day trading with taxes, you should seek professional advice from an accountant and/or the IRS.

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