A frequent trader, especial a day trader, may become familiar with certain stocks and trade them repeatedly over short periods. This kind of activity might be profitable but also faces unique obstacles. Rapid in-and-out trading of this type removes access to tax breaks for qualified dividends and long-term capital gains. It requires precise bookkeeping and drives up commission costs. It also will run a trader afoul of the wash rule, which eliminates the tax deductibility of losses.
A long position is one in which you buy securities in the hope their price will increase. You can characterize each stock purchase by what you buy, when you buy it, the number of shares and the price per share. The cost basis of a share is its cost, including its fair share of commissions and fees. Each purchase you make opens or extends a “tax lot," which is a record of pertinent data about a trade. You close a tax lot, wholly or partially, by pairing a sale of the same security to one or more existing tax lots.
Tax Lot Ordering
By tracking all of your trading activity by tax lot, you can specify which tax lot(s) to close when you sell a security. For instance, you can minimize your profit or maximize your loss on the sale of a particular stock by closing the tax lot with the highest cost per share. There are several automatic schemes available if you don’t want to manually manage your tax lots, including first-in, first-out, last-in, first-out and average value. When you sell a security, you realize the profit or loss calculated from the tax lots. You must pay taxes on realized profits, unless they occur in a tax-sheltered account.
The Internal Revenue Service defines a wash sale as “when you sell or trade stock or securities at a loss, and within 30 days before or after the sale you: buy substantially identical stock or securities; acquire substantially identical stock or securities in a fully taxable trade; acquire a contract or option to buy substantially identical stock or securities; or acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.” For example, if through a sale you close a tax lot on 100 shares of XYZ Corp for a loss and then open a new lot by purchasing 100 shares of XYZ within 30 days, you cannot deduct the original loss on the shares. If the tax lots are separated by more than 30 days, the tax-deduction is allowed.
You get a tax break on capital gains if you hold a security for more than a year before you sell it. You also get a tax break on qualified dividends if you hold a stock for at least 60 days surrounding its dividend date. If you are pumping in and out of the same stock in short time periods, you forfeit these tax breaks and must pay the income taxes at your marginal tax rate. You must also avoid breaking the Securities and Exchange Commission's Regulation T. For example, suppose you sell a stock and immediately use the proceeds to buy stock. If you then sell the second stock before the first sale settles -- stock settlement requires three days -- and you had insufficient account funds to buy the second stock without using the first sale’s proceeds, you have practiced “freeriding," which Regulation T punishes with fines and suspensions.
- Day Trading For Dummies; Ann C. Logue
- The Compleat Day Trader, Second Edition; Jake Bernstein
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