It's that time of year for everyone to close the books on 2009. For the biggest banks/funds on the Wall Street, this means some old fashioned window dressing as well as other performance enhancing tactics. Thankfully, there may be ways you can enhance yourperformance too-with tax deductions.
For the record, I'm not a tax professional, but I've learned many good strategies that can help traders cope with tax season. In fact, BigTrends Insiders (free membership) will be invited to attend a free Trading Tax webcast early next year. As a primer I recommend reading today's TrendWatch to learn if you can deduct your trading expenses before your books close for 2009. As you already know, the tax code provides incentives for many that are targeted at specific businesses like trading, but how do you qualify? There is a beneficial tax status for some of us that could save you money, thus preserving returns and exploiting losses. Will you be able to deduct your trading expenses for 2009?
At BigTrends we don't classify ourselves in one trading category like "day traders," "swing traders" or "buy and hold investors," but don't worry the Internal Revenue Service does. Of course, it can be difficult for experienced traders, like you, to pin themselves as one single type of investor too. To avoid confusion the IRS categorizes you as a trader or investor and this is important for everyone to understand whether you're at the beginning or end of a fiscal year. There are two ways to identify yourself with regards to your tax return and trading, an investor or a trader. It's good to categorize yourself as a trader for tax purposes so let's find out who is a trader and why.
Before we expose the advantages of being considered a trader we should take a glimpse at an investor, after all that's what Uncle Sam considers most of us. The IRS identifies three criteria to meet to be considered a trader, if you do not meet all three you are an investor.
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The rules are fairly simple for investors. If you have gains; the tax rate is determined based on the holding period, one year being the decisive break point. For investors the diamond in the ruff is a capital loss deduction. For losses from investment activities you may deduct up to 3,000 per year (you may carry over to future years indefinitely). Depending on your situation this may or may not be helpful. Also, investors can also choose which shares they sold if complete liquidation did not occur during the sale. This means you can choose to sell the security/shares with more or less basis (if you purchased the same security at different prices). These are good strategies to use if you have gains that you would like to offset.
I've always heard that when there's a party, the IRS will always come crash it. In recent headlines we've seen this to be true with private equity executives and their definition of carried interest compared to wages. There is still a party going on for traders though; if you can meet the three IRS criteria of a trader you essentially have the deduction power of a small business.
Before we talk about the three criteria you must meet to be a trader, let's discuss what the benefits include:
Have you ever come up with the genius idea to sell a stock to take the loss and then repurchase the same stock and continue to hold it? If so, you found out that the IRS crashed that party pretty fast-it's the wash sale rule and its illegal. Mark-to Market Traders are exempt from this rule because they book all gains and losses the end of the tax year whether or not the security is actually sold. This imaginary accounting allows you to start the year with no unrealized gains or losses. It's like taking a loss on a position without selling the actual security. Take a look at this IRS webpage to determine if you qualify as a 'trader in securities.'
Another significant advantage in meeting the IRS three requirements deals with deduction of expenses. If you bought a computer to use specifically for trading you can deduct that expense. The same definition applies to investment newsletters, subscriptions etc. Yes that's right, that ETF Options Trader subscription you just purchased may be deductible. From the IRS perspective you are running your own business and expenses are treated as such.
If you have never owned your own business then you may be unaware of the power of above-the-line deductions. As a trader you can deduct meaningful amounts of trading expenses to reduce your adjusted gross income! Now that's a party [tax proper] that I want to be invited to. There are limitations. Take a look at this link to a frequently asked question on the IRS website.
Are you ready to find out what the three IRS criteria are to be classified as a trader?
A lot of people arrived at this party in the past that were not invited; they wanted the benefits of becoming a trader. Many of these uninvited attendees were challenged by the IRS leading to a wealth of information like tax court decisions and private letter rulings (available to the public). The rulings hack away at the ambiguity to help you make a better decision. To avoid any challenges it is best to consult your personal accountant.
- 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, and
- You must carry on the activity with continuity and regularity.
IRS Link to help you determine if you are a 'trader in securities'
While these criteria may seem like fundamental assumptions of your situation, they may not be. For most of us interested in seeking this "designation" it's worthwhile to speak with a tax professional. It is also important to read the fine print, for instance you may engage 35 hours a week in research but if a broker "pulls-the-trigger" that is not valid. Finally, for those of you having some serious fun with your individual retirement accounts cannot include that time spent towards trader status.
Andrew Hart
Portfolio Manager, ETF Options Trader
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