Under Internal Revenue Service regulations, qualified day traders pay significantly less tax than occasional investors. The IRS has three tests that determine if you are a qualified trader. First, your trading goal must be to profit from daily price changes in the securities you trade; receiving interest or dividend payments does not quality as trading activities. Second, your trading activity must be substantial. Third, you must trade on a regular and continual basis. If you do not meet all the qualifications, the IRS classifies you as an investor, making your trading profits and losses subject to capital gains taxes.
Qualify as a Trader in Securities
A qualified day trader’s profits are taxed as ordinary income instead of capital gains. Profits are offset dollar-for-dollar by losses. There is no threshold limiting the amount of losses you can deduct, and you can carry any losses forward to reduce your future tax liability. Trading expenses, which includes trading commissions, are deducted from the trade’s profit to reduce your taxable income or added to a loss to increase your deduction.
Form a Corporation
You can form a corporation to reduce your tax liability. If you form a C corporation, profits and losses belong to the corporation and are taxed at the corporate rate. A one-owner corporation has the same advantages of a large publicly traded firm. Day trading profits can pay for your health care plan, insurance coverage and employee fringe benefits. Two or more day traders can consider forming a Limited Liability Company. LLCs are taxed as partnerships so the profits and losses flow directly through to the members.
Avoid Wash Sale Rules
Wash sale rules will not apply to you as long as you qualify as a trader of securities under IRS regulations. A wash sale occurs when you lose money on a trade, then purchase or acquire the identical security within 30 days after the loss occurred. You cannot deduct this loss to offset the profit earned from other trades. Instead, you must add the loss to the costs incurred when you repurchased the same security.
Make the Mark-to-Market Election
If a day trade turns into a long-term trade and remains open at the end of the year, you can get another tax break with the mark-to-market election. Under the mark-to-market election, the security is treated as though you sold it on the last day of the year. The gain or loss is treated as ordinary income. If you do not make the mark-to-market election timely, the gain or loss is taxed as a capital gain or loss. You can take the mark-to-market election whether you use a cash or accrual accounting system.
- IRS Tax Topics: Topic 429 - Traders in Securities (Information for Form 1040 Filers)
- Boyer Tax Services: Taking the Expressway to Trading Success: How the Proper Formation of a Business Entity Can Place You in the Fast Lane to Profitable Trading!
- IRS Publication 550: Part 4. Sales and Trades of Investment Property
- Taxes for Traders: Mark-to-Market
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