An individual defined by the Internal Revenue Service as a trader in securities experiences a different way of reporting investment income and expenses than regular investors. You determine if your active stock trading makes you a trader in securities by assessing general facts and circumstances rather than following an exact set of rules. For example, an active stock trader may qualify as a trader in securities for tax purposes and still hold some stock for long-term investment.
An investor is normally identified as someone who buys and sells securities with an expectation of income from dividends, interest, or capital appreciation. Investors report those types of income on distinctive tax return schedules. An investor is allowed to deduct investment expenses -- such as fees for investment advice and publications -- only as miscellaneous itemized deductions. Deducting this category of expenses from taxable income is limited to the amount that exceeds 2 percent of adjusted gross income. Interest paid on money borrowed to acquire securities is tax-deductible only when it does not exceed investment income.
Capital Gains and Losses
Gains and losses from an investor’s sales of stocks are reported on Schedule D, which is attached to a personal tax return. The difference between the sales proceeds and the owner’s basis in the stock is the gain or loss. Normally, basis is the original cost. Long-term sales of stock held for more than one year are segregated from short-term transactions. Investors are taxed on the net amount of gains after subtracting losses. A loss is deductible against other sources of income up to $3,000 per year for most tax returns.
Traders in Securities
A trader in securities seeks profit from daily market movements in stock prices rather than dividends and capital appreciation. You are classified as a trader in securities if your trading activity is substantial, plus you conduct trading activity continuously and regularly. Despite this subjective standard, you follow certain guidelines to determine if you meet qualifications as a trader in securities. The factors you consider include your typical holding period for stocks, your trading frequency and dollar amount of your trades, the extent to which you rely upon trading income for a livelihood, and the amount of time devoted to trading.
Taxed as Business
Traders in securities report their expenses related to trading stock as a business activity on Schedule C of their tax returns. The limitations incurred by investors on deducting investment expenses do not apply to traders in securities. Any dividends received by traders in securities and their stock trades are taxed just like those events for investors, unless the trader in securities makes a special election to use the mark-to-market method of accounting. This system is available to traders in securities, but not investors.
Mark to Market
The mark-to-market process entitles the trader in securities to adjust each stock at year-end to its market value. That triggers a gain or loss, which is the difference between original cost and year-end market value. The year-end market value then replaces original cost as the trader’s basis in the stock. Gains and losses by a mark-to-market trader in securities are reported on Part II of Form 4797 as the sale of business property. This is the business income of the trader in securities, without the limitation on deducting capital losses.