Trading Taxes in the US
Day trading taxes in the US can leave you scratching your head. Yet, if you’re marking hundreds or even thousands of intraday trades each year, it’s in your interest to understand how Uncle Sam will view your habit. Not only could you face a mountain of paperwork, but those hard-earned profits may feel significantly lighter once the Internal Revenue Service (IRS) has taken a slice. This page will break down tax laws, rules, and implications. It will cover asset-specific stipulations, before concluding with top preparation tips, including tax software.
Investor vs Trader
So, how does day trading work with taxes? Intraday income tax will depend on which category you fall into, ‘trader’ or ‘investor’. Unfortunately, as an IRS spokesman pointed out, “The question is clear; the answer isn’t.” So, you’ll need to follow the guidelines set out in the 70,000 page long tax code and take into account decisions in relevant case law.
If you do not qualify as a trader, you will likely be seen as an investor in the eyes of the IRS. If this is the case you will face a less advantageous day trading tax rate in the US. You will have to account for your gains and losses on form 8949 and Schedule D. Your expenses will fall under the category of “miscellaneous itemized deductions.”
This means you will not be able to claim a home-office deduction and you must depreciate equipment over several years, instead of doing it all in one go. Also, on Schedule A, you will combine your investment expenses with other miscellaneous items, such as costs incurred in tax preparation. You can also only write off the amount that exceeds 2% of your adjusted gross income.
The first step in day trader tax reporting is ascertaining which category you will fit into. 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 crucial 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 nowhere in the lengthy tax code is ‘trade’ or ‘business’ clearly defined. Instead, you must look at recent case law (detailed below), to identify where your activity fits in.
Do you spend your days buying and selling assets? If so, you are probably going to fall under the ‘trader’ umbrella. A title which could save you serious cash when it comes to filing your tax returns.
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.
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 had 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.”
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’re 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.
The US day trading tax rate looks favorably on the ‘trader’. So, meeting their obscure classification requirements is well worth it if you can. 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. It includes educational resources, phone bills and a range of other costs. However, it’s important you keep receipts for any items, as the IRS may request evidence to prove they are used solely for trade purposes.
On the flip side, if you are classed as a trader, you can write-off just the amount that exceeds 2% of your adjusted gross income. Not to mention that Schedule C write-offs will adjust your gross income, increasing the chances you can fully deduct all of your personal exemptions, plus take advantage of other tax breaks that are phased out for higher adjusted gross income levels.
Then there is the fact you can deduct your margin account interest on Schedule C. Throw in that you don’t have to pay self-employment tax on your net profit from trading, and you realize, it’s a pretty sweet deal.
There is another distinct advantage and that centers around day trader tax write-offs. Normally, if you sell an asset at a loss, you get to write off that amount. However, if you, a spouse, or company you control buys the same stock within 30 days, the IRS deem this a ‘wash sale’ (further details below). This brings with it a considerable tax headache.
Fortunately, you can jump this hurdle if you become a ‘mark-to-market’ trader. This will see you automatically exempt from the wash-sale rule.
This is what you do: On the last trading day of the year, you’d pretend to sell any and all holdings. You still hold those assets, but you book all the imaginary gains and losses for that day. You’d then enter the new year with zero unrealized gains or losses. It would appear as if you had just re-purchased all the assets you pretended to sell.
This brings with it another distinct 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 amount of losses. If you’ve had a poor trading year, this could save you considerable sums.
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.
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 rules page.
So, how to report taxes on day trading? If you’re 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.
You can’t join the nation’s most successful traders, such as Bruce Kovner and George Soros if you fall at the tax hurdle. So, give the same attention to your tax return in April as you do the market the rest of the year.
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 shouldn’t put up a fight if you declare your takings as a day ‘trader’ on your tax return.
It’s also worth bearing in mind you can be both a ‘trader’ and ‘investor’. However, if you were to go down this route, you’d have to separate your long-term holdings and keep detailed records to distinguish between both sets of activities.
You can’t get to grips with trading tax in the USA without understanding the essential tax jargon. A few terms that will frequently crop up are as follows:
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.
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 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’ll be taxed at the usual rate. However, hold the position for over a year and you can benefit from a lower tax percentage rate, often around 15%, but depending on your income, could also drop to just 5%.
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 received when selling it short. You’ll often find for the purposes of taxes for day trading, you can write off (deduct) capital losses, up to the number of capital gains you’ve 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’ll 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’re trading in a variety of instruments. However, on the whole, the IRS is more concerned with why and how you’re 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.
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.
Keep A Record
Many traders get to mid-April and suddenly realize the IRS doesn’t just want to know your profit and loss on each sale, but they also want a detailed description. If you want a straightforward day trading taxes rate, you’ll need to keep a record of the following:
- Purchase & sale date
- 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. Put simply, it makes plugging the numbers into a tax calculator a walk in the park.
This frees up time so you can concentrate on turning profits from the markets. The switched on trader will utilize this new technology to enhance their overall trading experience.
Day trading and taxes are inescapably linked in the US. Taxes on income will vary depending on whether you’re classed as a ‘trader’ or ‘investor’ in the eyes of the IRS. Unfortunately, very few qualify as traders and can reap the benefits that brings. For those who are tempted to tweak their records in pursuit of the ‘trader’ classification, be warned the consequences of failing to pay the correct amount, or late payments, can result in severe ramifications. These can range from financially crippling fines and even jail time.
Note this page is not attempting to offer tax advice. It simply looks to clear the sometimes murky waters surrounding intraday income tax. If you remain unsure or have any other queries about day trading with taxes, you should seek professional advice from either an accountant or the IRS.