Taxes are the most complicated set of hoops that a day trader must pass through while informing about his gains as well as losses. You can be a full-time trader making a living out of it, or just someone doing it part-time to reach long-term saving goals.
Regardless of which group you belong to, there is a wide range of tax implications that can affect when and how you calculate your tax refund.
You might be making hundreds or thousands each year in day trading, but it’s essential to know how Uncle Sam looks at your earnings. After all, once the IRS (Internal Revenue Service) has taken its share away, profits can feel seriously lighter.
So, here is a brief rundown on the tax laws and regulations that you need to know as a day trader in America. Read on to optimize your trading strategies and prepare yourself better.
Classification of a Trader
The first thing you need to ascertain is whether or not you are classified as a trader. Recent cases and day trading tax regulations state that you are a trader when you meet the requirements stated in Endicott vs. Commissioner, TC Memo 2013-199.
The requirements are as follows:
- You spend a considerable amount of time in trading. This ideally has to be your full-time profession. However, if you are a part-time trader, you’ll have to buy and sell several assets almost every day.
- You should show a consistent pattern of how to make a high number of trades. It should be done almost every day when the market remains open.
- The aim should be to earn profits from short term price fluctuations and not long-term gains.
- You should have an idea about the basic terminologies of taxes, like cost basis, capital gains, capital losses, taxes on particular assets, and futures.
Tax Benefits for Traders
Day trading tax rates in the US are somewhat favorable for the traders because you’re a self-employed professional to IRS. So, you get to deduct all the trade-related expenses under Schedule C.
It includes any office and home equipment, phone bills, educational resources, and several other expenses. But, save the receipts for all expenses because the IRS might ask for proof that you’ve used these for trade purposes only.
On the other hand, classified as a trader means you get to write-off only the amount that is more than two percent of the adjusted gross income. The write-offs for Schedule C will adjust the total income.
It will increase the chances of fully deducting all the personal exemptions. This will also let you have other tax breaks that remain discontinued for the higher levels of adjusted total earnings.
You can take away margin account interests on Schedule C, as well. Now, considering you won’t need to shell out self-employment taxes on the net profit, it’s a great deal.
The tax write-offs for day traders come with another significant advantage. Usually, you have to write off the amount after selling an asset at a loss.
If you, your company, or your spouse purchase this same stock within thirty days, this is deemed a wash sale by IRS. We will get to that in a while.
You become the mark-to-market trader if you can overcome this hurdle. It will get you exempted from that wash-sale rule.
You can do this by pretending to sell all holdings on the last trading day of a year. Keep holding the assets, but book all the losses and gains for that day. You’ll go into the New Year with no unrealized losses or gains.
It would seem like you have re-bought the assets that you fake-sold the previous day. You can try using trading tools like Alpaca to get the actual results and gain a better understanding of this situation. Just keep the market close time in mind while pretending to sell or re-purchase.
This brings us to another interesting advantage that day traders can avail. Investors can usually deduct about $1,500 or $3,000 in net capital losses every year.
However, mark-to-market traders have no limits on the number of losses they can deduct. This can help you immensely if you have had a bad year of trading.
When it comes to day trading tax losses, wash-sale is a crucial point. The IRS rules prevent the traders from asking for the losses for trade sales of securities in the wash-sale.
A wash-sale happens when you are trading securities at a loss. But, within 30 days of the sale, you, your spouse, or partner buy a considerably similar instrument.
If following the rule, the IRS does not consider the loss, you will have to include it in the total value of a new security. It will become a cost basis for this new security after this.
Reporting Taxes for Day Trading
As a day trader, you must inform about your losses as well as profits on Schedule D and form 8949. You only get to deduct $3,000 in terms of net capital losses every year. But, the amount is $1,500 when you are married and have separate filing statuses.
Schedule C will have only expenses in this case, according to the trading profits under Schedule D. If you have any confusion regarding this, keep a statement outlining your situation.
Taxes and day trading are closely linked in America. And, taxes on incomes vary based on whether you’re seen as an investor or a trader by the IRS. It’s also true that many fail to qualify as traders and enjoy the benefits that come with it.
However, if you are thinking about tweaking your records to get classified as a trader, it is better if you don’t try that. Failing to pay up the right amount or paying late can lead to serious consequences. And, serious in this case means anything between huge fines to jail time.
Hopefully, this has clarified some of your doubts regarding day trading and taxes. For further explanation of the matter, it is best to seek professional advice from the IRS or an accountant.