Is trader status right for you?

Many people make a distinction between investors and traders, but the Internal Revenue Service generally does not.

Whether you make three trades a year or three hundred, the IRS generally looks at your trades and any gains or losses the same way for tax purposes.

However, different rules apply to taxpayers 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 make the mark-to-market tax election (also known as a Section 475(f) election) and report your trading income in accordance with such tax election, it can significantly change the federal income taxation of your trading activities, which may have benefits for certain traders.

To understand if tax trader status and the mark-to-market tax election is right for you, and to plan your trading activities to help maximize 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.

Even if someone makes dozens of trades a month, the IRS considers them an investor if they primarily seek income from dividends, interest, and capital appreciation. For the IRS to consider you a trader in securities, you must aim to make money not from those sources but instead from daily or short-term market movements. Plus, you’ll need to show substantial trading activities conducted with continuity and regularity. Some specific factors that come into play include:

• Typical holding periods for securities
• The frequency and amount of each trade
• The extent to which you use trading produce income for a livelihood
• Amount of time devoted to trading

A determination of tax trader status is very fact-specific and involves applying established tests. A tax advisor should be able to apply these tests to your trading activities to see if you qualify. In most cases, you’ll need to make several trades per day, several days per week. If your 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 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.

As you know, when an investor makes a profit on a trade, the profit will normally be taxed as a federal short-term or long-term capital gain, depending on how long they held the investment.

• Depending on your tax bracket, the tax rates on short-term capital gains tend to be much higher than those on long-term capital gains.
• Investors are also subject to the wash sale rule that disallows loss deductions when a position or “substantially identical” position is closed and reopened within a certain time window.

Traders with tax trader status on the other hand:

• Always owe short-term capital gains taxes on any profits from trading activity.
• Are also eligible to make the mark-to-market tax election and then report the year's trading activity under "mark-to-market" rules. This means that they can report the year's gains and losses as if all open positions were sold at the end of the year and immediately repurchased at the beginning of the next year.

This tax election has two effects:

• 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 mark-to-market tax election, trades that are covered by that election are exempt from wash sale rules.

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 of the mark-to-market tax election—fewer limits on loss deductions, eliminating wash sale considerations, and others—worth it for you in your circumstances?

To get the answers, we recommend that you speak in detail to a tax planning professional who can walk you through the potential pros and cons.