Most taxpayers who trade stocks are classified as investors for tax purposes. This
means any net gains are going to be treated as capital gains vs. ordinary income.
That's good if your net gains are long term from positions held more than a year.
However, any investment-related expenses (such as margin interest, stock tracking
software, etc.) are deductible only if you itemize and, in some cases, only if the
total of the expenses exceeds 2% of your adjusted gross income.
Traders have it better. Their expenses reduce gross income even if they can't itemize
deductions, and not just for regular tax purposes, but also for alternative minimum
tax purposes. Plus, in certain circumstances, if they have a net loss for the year,
they can claim it as an ordinary loss (so it can offset other ordinary income) rather
than a capital loss, which is limited to a $3,000 ($1,500 if married filing separate)
per year deduction once any capital gains have been offset. Thus, it's no surprise
that in two recent Tax Court cases the taxpayers were trying to convince the court
they qualified as traders. Although both taxpayers failed, and got hit with
negligence penalties on top of back taxes, the cases provide good insights into what
it takes to successfully meet the test for trader status.
The answer is pretty simple. A taxpayer's trading must be "substantial." Also, it must
be designed to try to catch the swings in the daily market movements, and to profit
from these short-term changes rather than from the long-term holding of investments.
So, what counts as substantial? While there's no bright line test, the courts have
tended to view more than a thousand trades a year, spread over most of the available
trading days in the year, as substantial. Consequently, a few hundred trades,
especially when occurring only sporadically during the year, are not likely to pass
muster. In addition, the average duration for holding any one position needs to be
very short, preferably only a day or two. If you satisfy all of these conditions,
then even though there's no guarantee (because the test is subjective), the chances
are good that you'd ultimately be able to prove trader vs. investor status if you
were challenged. Of course, even if you don't satisfy one of the tests, you might
still prevail, but the odds against you are presumably higher.
If you have any questions about this area of the tax law or any other tax compliance
or planning issue, please feel free to contact us.
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