Day trading stocks is a fast-paced, high-adrenaline job with huge potential rewards — and huge potential losses. It can also include some really sweet tax breaks if you qualify as a trader in the eyes of the IRS.
That’s a big “if.” Many people who buy and sell stocks on the side — that is, they have a full-time job that doesn’t involve trading — are considered “investors” by the IRS, rather than “traders.”
Ordinary investors are also eligible for some tax breaks. Most notably, if they hold investments for a year or longer, they’re eligible for long-term capital gains rates, which are lower than regular income tax rates. But investors’ tax breaks pale in comparison to those available to full-fledged day traders.
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3 active trader tax breaks
Because traders don’t hold on to securities for long, they don’t usually qualify for long-term capital gains rates. But if you qualify, you can receive other valuable tax benefits:
Trading expense write-offs. Expenses related to trading are deductible as business expenses. This is potentially a much more valuable set of deductions than what ordinary investors can claim. For example, you can claim a home office for your business. Investors can deduct only investment expenses that exceed 2% of their adjusted gross income (investment expenses fall under “miscellaneous itemized deductions”).
Deductions from losses. As a trader, each year you can use all of your losses to reduce your taxable income, assuming you made a Section 475 “mark to market” election with the IRS. You must make this election by the filing deadline for your previous year’s return. For example, if you want to elect Section 475 for the 2018 tax year, you'd have to do it by April 17, 2018. Investors can reduce their taxable income by a maximum of $3,000 worth of capital losses per year.
Wash-sale rule exemption. The wash-sale rule is a tough one for ordinary investors, because it prohibits them from claiming a loss on a stock if they bought a “substantially identical” stock either 30 days before or 30 days after the loss sale. But active traders don't have to worry about that rule, as long as they made the Section 475 election.
Do your research — and consider consulting a tax pro — before claiming the Section 475 election. It’s not for everyone. For example, you might be better off avoiding it if you're focused on futures, because certain contracts qualify for a beneficial “60/40” tax rate: 60% long-term capital gains and 40% short-term gains, says Robert A. Green, a certified public accountant and CEO of GreenTraderTax.com in Ridgefield, Connecticut.
And remember: You must plan. Seek advice in December or January for the tax year ahead, suggests Alan J. Straus, a CPA and attorney in New York City.
Do you qualify as a trader?
There’s no statute or regulation that separates traders from investors, but plenty of cases have gone to tax court. Tax experts use those cases to guide clients.
One thing is clear: It’s not easy to qualify as a trader. Some of the largest hedge funds have investor tax status rather than trader tax status, Green says.
Robert A. Green, CEO, GreenTraderTax.com
Trader tax status is 'for the very active, the hyperactive, trader.'”
Trader tax status is “for the very active, the hyperactive, trader,” Green says.
Here are some general rules for those who hope to qualify as a trader with the IRS, according to Green:
You should be making at least four trades per day, four days per week
Your average holding period must be less than 31 days. If you want to hold some securities longer, segregate them in a separate brokerage account. For that portfolio, you’ll be treated as an investor.
You should spend about four hours per day working as a trader, including research and administration. “If someone is spending half an hour a day, they’re just not putting enough into it,” Green says.
You should have a “significant account,” Green says. “If someone has an account at $2,000 or $5,000, it’s not serious enough for the IRS.”
You should be treating day trading as a business, with the necessary equipment, software and research tools
In one court case, Straus says, a social studies teacher claimed that he qualified as a trader, rather than investor, because he traded during his two free prep periods every day.
“The court ruled against him,” Straus says. “That doesn’t really do it.”
Tax breaks for regular investors
If you don’t qualify as a trader, all is not lost (and you’re more likely to keep your shirt). Investors qualify for tax breaks, too, including these:
You enjoy a low capital-gains rate on investments held for a year or longer
You can reduce income by up to $3,000 worth of capital losses and carry additional losses into future years
You can deduct investment-related expenses to the extent that they’re greater than 2% of your adjusted gross income. This falls under the miscellaneous expense deduction, so other, noninvestment expenses might help push you above the threshold.