Tax Savings For Stock/Security Traders.
A taxpayer who trades securities, reports his/her trades on schedule D of form 1040. He/she is subject to the $3,000 annual limitation that applies to net realized capital losses. Also, securities are subject to the Wash Sales rules (in a nut-shell; loses will not be recognized for tax purposes if you sell a security at a loss and within 30 days you buy identical security). However, if you devote a great deal of time (see later what this means) trading stock, bonds, options or any other security, you might be able to qualify as a Trader for tax purposes.
This is accomplished by electing IRS Code Sec 475(f), also know as mark-to-market (M2M). By doing so, the Trader elects to mark his/her stock holdings to market at the end of the year. Under this method, all gains and losses are treated as ordinary income or loss. All the securities held as of December 31st are deemed to be sold at the year-end market value. If you were profitable, the realized capital gains from trades are not subject to Self-Employment tax, under IRC Sec 1402 (a)(3)(A). So by making this IRC Sec 475(f) election, a Trader avoids the $3,000 limitation on net capital losses and also he/she is not subject to the Wash Sale rules. If you made mark-to-market election you should report all gains and loses in Part II of Form 4797, instead of Schedule D. Once this election is made, it become irrevocable and cannot be changed without prior approval from the IRS. With mark-to-market, you elect to treat open positions as being sold on the last day of the year at Fair Market Value and immediately re-acquired at FMV in first day of the following year.
After making this election, you also should change the method of accounting by filing Form 3115 Application for Change in Accounting Method as outlined in the Revenue Procedure 2008-52. The 3115 should be attached to the 1040 for the first effective year, and a copy should be sent to the national office. See “Special Rules for Traders in Securities” in Publication 550. Because you are changing the accounting method, you need to figur out the Sec. 481 (a) adjustment.
Example: At the end of 2010 you held shares with $26,000 in cost basis (your cost or purchase price) but value of $28,000 (the FMV of those shares at the end of the year). You made the mark-to-market election effective beginning in 2011. On 1/1/2011 the FMV of those shares is $32,000. You will report $4,000 of capital gain (32,000-28,000), in addition, you have also a Sec. 481(a) adjustment of $6,000 (32,000-26,000) in the first year you made the change. The Sec. 481(a) adjustment is the unrealized gain or loss in a trader’s trading account at the end of the prior year. In other words, it is the difference between the cost of the securities owned at the end of the prior year and the market value on January 1st of the following year.
After the Sec. 481(a) adjustments is calculated and the result is positive, i.e. you have a gain, you may either spread out that gain over four taxable years or elect to take the entire gain as Sec. 481 adjustment as long as it is below $25,000. However, if the Sec. 481(a) adjustment is greater than $25,000, a trader is required to prorate the adjustment on their income tax return over four taxable years. So, lets say your Sec 481 adj. is a 40,000, the first 10,000 is reported on form 4797 for the year of adjustment and the remaining 30,000 is devided evenly over the next three tax year. If Sec. 481 adjustment is negative i.e. you have a loss, the entire amount may be taken in the year of change. (Rev. Proc. 2002-19)
A Trader who materially participates in trading business, can also deduct other ordinary and necessary expenses on schedule C of form 1040. See the list of common deductable expenses below. Otherwise, these expenses are reported on schedule A of form 1040 subject to 2% AGI floor.
Note that the security trades should be accounted for by matching purchases (cost basis) and sales (proceeds) on a FIFO (First In First Out) system, some exceptions apply.
The mark-to-market election must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. To make the mark-to-market election for 2011, you must file a statement by April 15, 2011. This statement should be attached to either your 2010 individual income tax return or to the extension to file that tax return. The statement should include the following information:
- That you are making an election under section 475(f) of the Internal Revenue Code
- The first tax year for which the election is effective
- The trade or business for which you are making the election
Tax Summary: If you make the IRC Sec 475 election for Securities/Commodities:
- Securities are not subject to the Wash Sale rule
- Losses in securities held at year-end are deductible over $3,000 general limit
- Gains in securities held at year-end are taxable as ordinary income not subject to SE taxes
- Gains in securities held over 12 months are not taxed at long-term tax rates rather at ordinary income tax rates
- Old Capital Loss Carry-forwards may be trapped on Schedule D
- §1256 contracts have no long-term gain rate for 60% of gains
- §1256 contracts are not limited for deductibility of any trading losses
Now you know all the benefits of IRC Sec 475 election. So the question is; do you qualify to be called a Trader for tax purposes, so you may use the IRC Sec 475 election? Well, many taxpayers will be surprised that most of them do not meet the requirements. So no Trader status, no mark-to-market election for you!
Here are just few basic and general requirements to meet the definition of a Trader:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
- Your activity must be substantial.
- If you make 1,000 trades or more during the year, this most likely would qualify you for Trader status.
- If you make between 500 to 1,000 trades during the year, often it can qualify you for Trader status, but you most probably be under more scrutiny during an IRS audit.
- Traders with less than 500 trades will have a tougher time substantiating trader status
- You must carry on the activity with continuity and regularity. So making trades everyday is a good habit.
See Holsinger v. Comm., TC Memo 2008 –191. There, a Trader is when a taxpayer trades at least 50% of all trading days.
As mentioned earlier, a Trader can also deduct ordinary and necessary expenses related to his/her trading business. Note that commissions paid to purchase or sale of a security are added to the cost basis of that security. Once applied, it reduces capital gains or increase capital loss when you sell that security.
Here are some of the most common tax deductions:
- Subscriptions to financial magazines and newspapers
- Trader guides and books
- Custodial fees
- Tax preparation fees, planning and advice
- Continuing professional education such as seminars, courses.
- Office Expenses: Telephone usage and long distance, cable, DSL, T1, cleaning and maintenance, rent, utilities, etc.
- Office supplies
- Wire fees
- Cell phone,
- Real-time quotes, charting and analysis
- Interest expense paid on loans used for the purchase of the securities
- Including, in certain circumstances, your credit card interest under the §1.163-8T general tracing rules.
IRS Circular 230 Legend: Any advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax payments or penalties. Unless otherwise specifically indicated, you should assume that any statement in this website or articles that relating to any U.S. federal, state, or local tax matter was written in connection with the promotion or marketing. Disclaimer: Any articles herein is designed for general information only. The information presented at this site should not be construed to be formal legal or tax advice. Each taxpayer should seek advice based on the taxpayer's particular circumstances.