Trading Taxes in the US
Trading taxes in the US are administered by the Internal Revenue Service (IRS). The IRS considers several factors, including whether an individual is engaged in the “business” or “trade” of selling securities. This guide explains the relevant tax laws, rules, and implications for US traders. It covers asset-specific stipulations before concluding with preparation tips, including the use of integrated tax software offered by online trading brokers.
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.
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 who qualify as a ‘trader in securities’ and make a valid section 475(f) mark-to-market election can generally avoid the usual wash-sale and capital-loss limitation rules on their mark-to-market trading positions.
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Investor vs. Trader
Intraday income tax depends on which category you fall into, “trader” or “investor.” Unfortunately, determining this classification is complex and often done on a case-by-case basis. The IRS discusses how it distinguishes traders from investors in its guidance for individual filers.
As such, the relevant standards are derived from tens of thousands of pages of tax law, regulations, and IRS guidance, along with decisions in relevant case law.
Investor
Those who do not qualify as a “trader” will likely be treated as an investor in the eyes of the IRS. This generally results in less favorable tax treatment for active trading activity in the US.
Most investors report sales of securities on Form 8949 and Schedule D (Form 1040). Many common investment expenses that used to be “miscellaneous itemized deductions” subject to a 2% of adjusted gross income (AGI) floor are currently no longer deductible for federal income tax purposes under current law, although investment interest expense can still be deducted on Schedule A to the extent of net investment income.
Because investing is generally not treated as a trade or business, investors ordinarily cannot claim the home-office deduction, and many expenses for equipment and tools used to manage personal investments are no longer deductible as miscellaneous itemized deductions under current federal law.
Under prior law, many investment-related expenses were grouped with other miscellaneous itemized deductions on Schedule A and were only deductible to the extent they exceeded 2% of AGI. These deductions have been eliminated for most taxpayers under current federal law, so many typical investment expenses (such as advisory fees) are no longer deductible at all on Schedule A, although investment interest expense remains separately deductible within its own limits.
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 returns typically derive from interest, dividends, and capital appreciation of their chosen securities.
The key difference in determining eligibility for 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 challenge is that “trade” or “business” is not clearly defined. Instead, you must look at recent case law (detailed below) to identify where your activity fits within the IRS framework.
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 cases tell us you’re a “trader” if you meet the requirements analyzed in Endicott vs Commissioner, TC Memo 2013-199. Endicott is frequently discussed in tax cases and commentary on how courts distinguish between “traders” and “investors.”
The two considerations were as follows:
- The individual’s trading was substantial.
And, - The individual aimed to profit from short-term price fluctuations in 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. He aimed to profit from the premiums received from selling call options against the corresponding quantity of underlying stock that he held.
He usually sold call options that had expiration terms 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, due to 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 asserted that 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 per 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 factors 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 on a frequent and continuous basis.
- 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.
If you qualify as a trader in securities, your trading activity is treated as a trade or business even though you have no customers. You generally report your trading-related business expenses on Schedule C (Form 1040), and these deductions reduce your adjusted gross income and are not subject to the former 2% miscellaneous itemized deduction floor.
However, your gains and losses from selling securities are still reported on Form 8949 and Schedule D unless you’ve made a valid mark-to-market election.
In addition, interest on money you borrow to trade (including margin interest) is generally treated as investment interest expense and may be deductible (typically on Schedule A) subject to the net investment income limits, 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. With a valid section 475(f) mark-to-market election, a trader’s qualifying trading positions are generally exempt from the usual capital-loss limitation and wash-sale rules, although wash-sale rules can still apply to separate investment or retirement accounts.
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 the discussion of the mark-to-market election in IRS Topic No. 429, Traders in securities, and in Revenue Procedure 99-17 in Internal Revenue Bulletin 1999-7.
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 (in section 1091 of the Internal Revenue Code) and prohibits traders from 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 purchases 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 qualify as a trader in securities but do not make a mark-to-market election, you still report your sales on Form 8949 and Schedule D and are subject to the usual capital loss limits (generally, up to $3,000 of net capital losses per year, or $1,500 if married filing separately, with excess carried forward).
If you have a valid section 475(f) mark-to-market election in place, your trading gains and losses are generally reported as ordinary income or loss on Form 4797 instead, and the capital-loss limitation does not apply to those mark-to-market positions.
Schedule C should then have just expenses and zero income, while your trading profits are reflected on Form 4797 (if a valid section 475(f) election is in place) or Schedule D (if no election has been made). 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 may be more likely to accept your classification 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 any commissions or transaction costs. It acts as a baseline figure from which 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 ordinary income tax rates. However, if you hold the position for more than one year, your profit is usually taxed at the preferential long-term capital gains rates, which are currently 0%, 15%, or 20% depending on your taxable income and filing status, and may also be subject to the 3.8% Net Investment Income Tax for higher-income taxpayers.
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 of net capital losses 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.
In many cases, day trading options is taxed similarly to stock trading, but some instruments, especially forex contracts, can fall under different rules (for example, section 988 ordinary income/loss or, in some cases, section 1256), so it’s important to confirm how a specific product is treated.
Retail spot forex transactions are typically taxed under section 988 as ordinary income or loss, unless a valid election is made for section 1256 treatment where permitted. Having said that, there remain some asset-specific rules to take note of.
Futures
Many exchange-traded futures and certain index options are “section 1256 contracts.” Gains and losses on these contracts are marked to market at year-end and treated as 60% long-term and 40% short-term, regardless of how long you held the position.
The 60% portion is taxed at the applicable long-term capital gains rate (currently 0%, 15%, or 20%, depending on your taxable income), while the 40% portion is taxed at your ordinary income rate. Section 1256 contracts are also not subject to the wash-sale rules and are automatically marked to market at year-end.
Not all futures or derivatives qualify as section 1256 contracts, so traders should confirm how a particular product is classified for tax purposes.
So, while many of the core concepts (such as whether you are treated as a “trader” or “investor”) apply across instruments, some products, especially certain forex contracts and section 1256 contracts, can be taxed under different Code provisions (such as section 988 or section 1256) that may result in ordinary income or blended 60/40 capital gains treatment rather than the standard rules that apply to share trading.
It’s therefore important to confirm how each specific product is treated for tax purposes.
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
- Cost basis adjustments (including commissions, wash sales, and corporate actions)
Having this information to hand will make taxes on trading US stocks a stress-free procedure. The IRS emphasizes maintaining detailed records of trades, including dates, prices, and basis, in its guidance on capital gains and in Publication 550. Active traders may also need these records to calculate quarterly estimated tax payments and support mark-to-market reporting, if applicable.
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 trading 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.
Regardless of the software used, traders remain responsible for verifying accuracy and ensuring that all elections, such as section 475(f), are properly documented and filed.
Net Investment Income Tax (NIIT)
In addition to standard capital gains tax rates, higher-income taxpayers may also be subject to the 3.8% Net Investment Income Tax (NIIT).
The NIIT applies to net investment income above certain thresholds, which is currently $200,000 for single filers and $250,000 for married filing jointly.
Net investment income is typically inclusive of interest, dividends, and capital gains.
For most investors, and for traders who haven’t made a section 475(f) mark-to-market election, trading profits may be included in the NIIT calculation if income exceeds the relevant threshold.
Note that NIIT is calculated separately from ordinary income tax. Accordingly, it increases the effective tax rate on profitable trading activity.
| Category | Details |
|---|---|
| Tax Rate | 3.8% additional tax on net investment income. |
| Income Threshold (Single) | Applies when modified adjusted gross income exceeds $200,000. |
| Income Threshold (Married Filing Jointly) | Applies when modified adjusted gross income exceeds $250,000. |
| Applies To | Interest, dividends, and capital gains above the applicable income thresholds. |
Quarterly Estimated Tax Payments
Active traders may be obligated to make quarterly estimated tax payments, depending on profitability. The IRS generally requires estimated payments if you expect to owe at least $1,000 in tax after subtracting withholding and refundable credits.
You can pay your full tax bill when filing your annual return, but you may owe an underpayment penalty if you didn’t pay sufficient tax throughout the year.
Under the safe harbor rules, you can generally avoid penalties if your total payments during the year equal at least:
- 100% of your prior year’s total tax liability, or
- 110% of your prior year’s total tax liability if your prior year adjusted gross income exceeded $150,000 ($75,000 if married filing separately).
These payments are required to be made evenly and on time throughout the year to fully satisfy the safe harbor requirements.
Making a Valid Section 475(f) Election
Section 475(f) permits a qualifying trader in securities to elect mark-to-market accounting. This means trading positions are:
- a) treated as sold at year-end and
- b) gains or losses are reported as ordinary income.
This has the effect of eliminating capital loss limits and wash-sale restrictions on those positions.
The section 475(f) mark-to-market election isn’t made automatically but nonetheless needs to be properly and on time. In most cases, the election has to be filed by the original due date of the prior year’s tax return (extensions don’t apply).
The election involves attaching a written statement to the timely filed return and filing Form 3115 (Application for Change in Accounting Method) with the IRS.
This process involves technical procedural requirements and specific deadlines. As such, many traders will seek out professional guidance before making the election.
Traders may ask if this can be done with, or is it supported by, (consumer-level) tax software? The answer is sometimes, but not always, and often not easily. In practice, many traders use a CPA for the first year of the 475(f) election. After it’s established, future years are easier.
Late elections (i.e., elections filed after the deadline) are generally difficult to obtain and may require IRS approval.
We know this can be confusing, but as a short checklist, 475(f) is most attractive for traders who:
- Trade frequently
- Generate large short-term losses
- Want to avoid wash-sale complexity
- Don’t rely on long-term capital gain treatment
It is less attractive for traders who:
- Hold positions longer term
- Generate consistent profits
- Value long-term capital gains rates
| Pros | Cons |
|---|---|
| No $3,000 capital loss limitation; losses are treated as ordinary and fully deductible in the current year. | All gains are treated as ordinary income; no preferential long-term capital gains rates. |
| Exempt from wash-sale rules on elected trading positions. | Election must be made in advance and requires Form 3115; generally cannot be applied retroactively. |
| Ordinary losses can offset other types of income, including wages and business income. | Applies only to designated trading positions; investment holdings must be segregated. |
| Simplifies year-end reporting by marking open positions to market. | May increase scrutiny if trader status and recordkeeping are weak. |
| Highly profitable traders may face a higher overall tax rate due to loss of capital gain treatment. |
Wash Sales and IRA Accounts
The wash-sale rule generally disallows a loss if you repurchase a substantially identical security within 30 days before or after the sale.
In most cases, the disallowed loss is added to the cost basis of the replacement security. Plainly, this means that the loss isn’t permanently denied. Instead, it’s deferred until you eventually sell the “replacement” security (in a taxable transaction).
However, if you trigger a wash sale by repurchasing the same or substantially identical security inside an IRA or other tax-advantaged retirement account, the loss may be permanently disallowed rather than deferred. In that situation, the disallowed loss isn’t added to the IRA’s basis and cannot be recovered later. This is because IRA accounts don’t track or adjust the cost basis for wash-sale purposes. As such, the disallowed loss can’t be added back and recovered in any future taxable sale.
Traders who use both taxable brokerage accounts and retirement accounts will need to monitor transactions carefully to avoid unintended wash-sale consequences.
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 such classification can provide, including broader expense deductions and potential mark-to-market treatment.
Traders should be warned that failing to pay the correct amount, or making late payments, can result in significant penalties and interest charges. These can include accuracy-related penalties, additions to tax for late payment, and potential underpayment penalties for failing to make required quarterly estimated tax payments, as described in the IRS guidance on penalties.