To be a successful day trader, an individual must have a keen knowledge of the financial marketplace and the wherewithal to transform intuition and analysis into profit. For many day traders, years of experience and hard work have helped them develop their own specific strategies and tactics for successful trading. Whether an individual frequently trades throughout the day or makes only a handful of critical decisions throughout the week, being a successful day trader is more than a full-time job – it is a lifestyle.
Day traders have a variety of options available to them which can help ensure that their tax liability is as small as possible. As a general rule, day traders must be considered qualified professionals by the IRS to avoid the capital gains taxes assigned to casual investors.
Profits vs. Taxes
For many day traders, the pressure of securing a profit in a volatile marketplace is compounded by indirectly related yet equally important issues, such as tax liability. Depending upon the specific tactics employed by a trader, their year-end tax liability could be frustratingly high. A thorough and comprehensive understanding of how tax on stock trading accumulates is absolutely necessary in order to ensure that an otherwise successful profession is not marred by cumbersome tax liability. Fortunately, there are a handful of relatively straightforward steps a day trader can take in order to begin reducing their tax liability and optimizing their overall profit in the process.
Exploring Day Trader Taxes
By far, the most important step a day trader must take in order to ensure that their tax responsibilities don't grow out of control is to obtain recognition from the IRS as a qualified trader rather than a casual investor. Although this may sound like an issue of semantics, there are distinct repercussions for the term assigned to you by the IRS. This is primarily due to the nature in which these two status are taxed by the federal government.
When a casual investor acquires profit from a trade in the marketplace, this income is taxed at capital gains rates. If the "investment" is held for less than a year, short-term capital gains rates apply, which are typically quite high compared to standard income tax. However, when a professional, IRS-recognized day trader acquires profit from a trade, this money is taxed at ordinary income rates. For both casual and professional investors, losses incurred during trades directly offsets acquired gains, thus helping to create a realistic portrayal of your actual income. However, from strictly a taxation perspective, recognized day traders receive far more advantageous tax treatment than casual investors.
Understanding Trader Tax Status
With that in mind, it should be a top priority for all day traders to achieve this professional recognition from the IRS, coined the Trader Tax Status (TTS). Typically, the IRS assesses the legitimacy of a day trader using three standards of measurement. First, IRS officials will explore your trading activity in order to determine whether you are actively day trading (this may sound obvious). In addition, the IRS will assess whether or not your trading activity is simply occurring often or is influenced by daily price swings of major stock indexes. Finally, the IRS will examine the regularity of your trades, ensuring that you are actually trading stocks on a regular basis throughout the working week.
Typically, you can assess your current trading activity and make a fairly accurate determination as to whether or not the IRS will consider you a professional trader. For example, if your trading activity displays no signs of routine (i.e. you aren't actively trading the markets on a daily basis), the chances are good that the IRS will be somewhat skeptical of your professional credentials and make continue to regard you as a casual investor. Regardless, you should be fully prepared to provide evidence of your professional status as needed in the event that the IRS launches a query into your trading activity.
Assessing Tax on Stock Trading
Although the aforementioned rules may seem somewhat obvious, they can provide a very thorough assessment of an individual's trading activity and help the IRS determine whether or not the individual in question is actually trading as a profession or is simply trying to evade capital gains taxes. After receiving recognition as a day trader, individuals will also be able to deduct the cost of commission fees and other brokerage expenses from their income, much like any self-employed individual or independent contractor would deduct the expenses that are vital to the successful operation of their business. Although prior to tax year 2018 casual investors were able to deduct these expenses as well, recent legislative actions have suspended the process of deducting miscellaneous itemized expenses such as investment fees.
Keep in mind that the specific nature of your trades will not directly influence the method in which you are taxed. Simply put, taxes on FOREX trading – a term used to describe the foreign exchange currency markets – are no different than taxes on options trading, even though the particular mechanisms of these trades differ significantly. Accurate documentation of all trades – including profits and losses – will help ensure that you document your day trading with enough precision to satisfy any IRS queries at any point in the future.
Avoid Unnecessary Taxes
In some circumstances, you may be able to diminish your tax liability even further by forming a corporation. Regardless of whether or not you work in conjunction with other day traders, you may be able to use the tax status of a corporation, more specifically a C corporation, to record profits and losses and take advantage of corporate tax rates. Any profits or losses that occur as a result of trading would automatically belong to the C corp, which, in many circumstances, could result in a far more cost-effective filing for you. In fact, profits you earn as part of your trading could be channeled through the C corp and transformed into payments on health insurance and various other benefits.
Moving forward, it is in your best interest to discuss your specific professional goals and activities with a tax expert in order to determine what specific steps you can take to further your agenda and diminish your tax burden. In some situations, you may discover that you have already optimized your status as a day trader and are taking advantage of available deductions and tax regulations to the fullest. However, many individuals typically discover that numerous options are available to them which will help reduce their bill during tax filing season. Particularly in situations where you are new to the tax filing responsibilities for day trading, it certainly doesn't hurt to seek advice from a third party.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.