Trader status: Talking about it with your tax advisor
E*TRADE from Morgan Stanley
Many people make a distinction between investors and traders, but by default the Internal Revenue Service does not. Whether you make three trades a year or three hundred, the IRS looks at your trades and any gains or losses the same way for tax purposes. However, there is an alternative tax status available to people who qualify as what the IRS calls a "trader in securities". You may also see it referred to informally as "trader status" or "tax trader status".
If you qualify for trader status and choose to report your trading income in that way, it can significantly change how your trading activities are taxed, which may have benefits for certain traders.
Obviously, to understand if tax trader status is right for you, and to plan your trading activities to maximize any potential benefits, you should discuss it carefully with your professional tax advisor. To help facilitate that discussion, let's go over some background information, as well as topics you can bring up with your tax pro.
What is trader status?
Even if someone makes dozens of trades a month, the IRS will consider them an investor if they primarily seek income from dividends, interest, and capital appreciation. To be considered a trader in securities, an investor must aim to make money not from those sources but instead from daily or short-term market movements. Plus, trading activities must be substantial and conducted with continuity and regularity. Some specific factors that come into play include:
- Typical holding periods for securities
- The frequency of trades and the amount of each trade
- The extent to which trading is pursued to produce income for a livelihood
- Amount of time devoted to trading
A review of tax trader status is very fact-specific and will involve applying established tests. A tax advisor should be able to apply these tests to an investor’s trading activities to see if they qualify. If the current level of trading activity doesn't meet the qualifications, a tax pro can offer guidance about how to make the necessary changes to qualify in the future.
It's worth noting that it's possible to report trading activity under the status of a trader in securities and, at the same time, carry out separate investing activities that are reported using standard investor status. A simple way to help manage this is to do the trading in one account (or accounts) and do the investing in a different one.
Differences in how gains and income are taxed and "mark-to-market"
As you know, when an investor makes a profit on a trade, the profit will normally be taxed as a short-term or long-term capital gain, depending on how long the investment was held. Investors are also subject to the wash sale rule that disallows loss deductions when a position is closed and reopened within a certain time window.
With tax trader status, gains from trading activity are always taxed as short-term capital gains. Those with trader status are also eligible to make what's known as a Section 475(f) election and then report the year's trading activity under "mark-to-market" rules. This means that the year's gains and losses are reported as if all open positions were sold at the end of the year and immediately repurchased at the beginning of the next year.
This has two effects. First, as we mentioned above, it eliminates the limits on deducting trade losses that apply to investors—i.e. tax traders are not limited to deducting only losses that are offset by gains, plus an additional $3,000. Secondly, with a valid Section 475(f) election, trades that are covered by that election are exempt from wash sale rules.
Next step: talk to your tax pro
We've just hit the highlights of trader status in this discussion. As with most things tax-related, there are a lot of variables and potential implications to consider. Does your trading activity qualify in the first place? Are the potential benefits—fewer limits on loss deductions, eliminating wash sale considerations, and others—worth it for you in your particular circumstances? To get the answers, we strongly recommend that you speak in detail to a tax planning professional who can walk you through the potential pros and cons.