Taxes for Trading Income
Tax season is upon us and we are all gathering our documents to bring to H&R Block, our Accountant’s office, or to input ourselves into Turbo Tax. No matter which method you’ll use to file your taxes, we all share the common stress and frustration of having to review thousands of trades from last year and try to understand why your taxes are going to be so high. Trading Income is subject to higher tax rates than regular income for a number of reasons. Most full time day traders are Self Employed and are subject to a 15% Self Employment tax. Additionally, all traders are subject to the wash sale rule unless you have specially filed to be a Professional Day Trader with the IRS. To make things easier, we have outlined a few important steps to take today that will make next year quick and painless. These tips will also help you prepare your taxes for last year but nothing is better than getting things organized ahead of time.
The first thing many day traders will notice is that we are automatically subject to the Wash Sale Rule. The Wash Sale Rule states that if you sell a stock and take a loss on it and you buy back that same stock within 30 days you can’t write off the initial loss from the first trade. This was initially designed to prevent long term investors from selling all stocks they were at a loss on and buying back at the same price so they could realize the capital loss for that tax year. The problem is that as a day trader we are flipping the same stocks so many times that we have to be able to write off the losses otherwise our gains will far exceed our losses. Think for example of a trader that only trades 10 stocks all year long. At the end of the year they may have 50k in losses and 100k in profits for a net 50k profit. That have to be able to write off those losses against the gains. The solution is that these trades can apply for Mark-to-Market accounting with the IRS. This is only available if you are a day trader.
Mark-to-Market accounting provides many advantages for Day Traders, but it also has some disadvantages. The advantage is that you can write off unlimited capital losses in a year and you are exempt from the Wash Sale Rule. This is clearly a huge advantage for a day trader but it would also be an advantage to a typical investor. A typical investor can only write off $3k in capital losses against their income, but as a Mark-to-Market filer, you can write off an unlimited amount in capital losses. As a result, many investors have tried to get Mark-to-Market status because there is such a big advantage for them. Due to the abuse of the system, the IRS scrutinizes anyone that is a Mark-to-Market trader to assure that they are in fact an active day trader. The disadvantage for a day trader is we have a lot of paperwork. We have to provide a written description of every single trade including Name, Price, Profit, Description. If you are doing this by hand you can expect to spend weeks taking these notes and driving yourself nuts. These days there is software that links directly to your stock broker to export all your trades and print them out in a way that is acceptable to the IRS. The advantages of Mark-to-Market accounting clearly outweigh the disadvantage when you are able to use software to export all the data. You should still plan to load up on printer paper and ink cartridges before you send these files to print.
Once you have prepared your tax materials you will have the nagging question, “what is my tax rate”? I’ve heard people criticize the idea of being a day trader because you have to pay short term capital gains taxes on the income. While that is the case for some day traders, it’s not black and white. If you have declared yourself as a professional day trader you will pay the regular income taxes based on your income bracket for the trading income. If you make $50k day trading you will not pay 20-30% short term capital gains taxes. You will pay the tax rate based on making $50k of regular income. On the other hand, if you are day trading out of the same account where you are also taking long term investments you may run into issues with capitals gains taxes.
Another important thing to remember is that if you have declared yourself as a professional day trader you can write off your business expenses. You will be paying self-employment tax in most cases so you want to make sure you are writing off the self-employed expenses such as NYSE data fees, Computer Equipment Costs, depreciation of Office Equipment, Office Furniture, etc. Keeping track of these expenses and saving receipts throughout the year is so much easier than trying to gather everything at the end of the year. Stay ahead of the curve this year and start tracking these costs now!
Taxes are a part of life. We deal with them every year and as investors and traders we have a particularly hard time. We have many more documents to gather and we are often waiting on brokers and financial advisers to give us the 1099’s. Make your life a little easier by following our tax season tips!
A Few Tips for Making Tax Season Easier
* Consult an accountant about Mark-to-Market status
* Separate your short term day trading account from long term investing account
* Consider having a second trading account structured as an IRA
* Make sure you are using a broker that supports integration with software for exporting day trade data for Taxes
* Record all your expenses related to day trading if you have declared yourself as a professional trader