Are You a Regular Investor or a Tax-Favored Securities Trader?Tax Planning
Recent stock market volatility makes us focus on the question of exactly who is eligible for the favorable federal income tax treatment accorded to individuals who trade stocks with sufficient intensity to be classified as securities traders in the eyes of the IRS.
Not-so-favorable federal income tax treatment applies if you trade stocks fairly actively but without enough vigor to be considered anything other than a garden-variety investor.
There’s no bright-line distinction between trader and investor status, so we must rely on court decisions to assess the issue. We will cover some illuminating decisions later in this article.
But first, let’s summarize the important federal income tax advantages of securities trader status for those who qualify. You may be among them—or not. Read on.
If You’re a Trader, You Can Deduct Expenses on Schedule C and Make the Taxpayer-Friendly Mark-to-Market Election
If you can be classified as a securities trader for federal income tax purposes, as opposed to being a garden-variety investor, you’re considered to be in the business of trading securities. That means you can deduct your trading related expenses on Schedule C of Form 1040. Good!
Garden-variety investors cannot deduct any of their investment-related expenses under our current federal income tax regime.
The most important advantage of trader status is that you’re eligible to make the taxpayer-friendly mark-to-market election. That election is not available to garden-variety investors.
When you have a mark-to-market election in force, you gain two important federal income tax advantages.
Advantage 1: Exemption from the Capital Loss Deduction Limitation
Because you are a mark-to-market trader, your trading gains and losses are simply considered business income and expenses, respectively. So, if you have an awful trading year, as many traders did in 2022, you can deduct your trading losses in full.
In contrast, if you’re a garden-variety investor, you’re subject to the $3,000 annual limit on deductible net capital losses, or $1,500 if you use married-filing-separately status. Ugh!
Advantage 2: Exemption from the Wash Sale Rule
Because you are a mark-to-market trader, your trading portfolio is exempt from the dreaded wash sale rule that would otherwise defer tax losses when you acquire substantially identical securities within 30 days before or after a loss sale.
When the wash sale rule applies, the disallowed loss is added to the basis of the substantially identical securities that triggered the rule.
Key point. Gaining an exemption from the wash sale rule via the mark-to-market election saves you from lots of non-productive calendar-watching and bookkeeping.
The Price of the Mark-to-Market Election
There are no free lunches.
As a trader who has made the mark-to-market election, you must pay a price for the aforementioned tax advantages. Here’s the price: On the last trading day of the year, you must pretend to sell your entire trading portfolio at market and book the resulting gains and losses for federal income tax purposes.
You’re then deemed to immediately buy back everything in your trading portfolio for the same prices. So, the securities in your trading portfolio begin the next year with tax basis equal to market value and with no unrecognized tax gains or losses.
But if you have little or nothing in your trading portfolio at year end, as may often be the case, these imaginary mark-to-market transactions have little or no tax impact.
Deadline for Making the Mark-to-Market Election
If you’re a trader who uses the calendar year for federal income tax purposes, you’ve already missed the deadline for making the mark-to-market election for your 2022 tax year, assuming you did not already make the election for an earlier year.
According to IRS rules, you must make the election for a calendar year by the unextended due date of your Form 1040 for the previous year. So, the deadline to make the election for your 2022 tax year was April 18, 2022. That’s way back in your rearview mirror.
Deadline alert. If you’re a calendar-year taxpayer, the deadline to make the mark-to-market election for your 2023 tax year is April 18, 2023. That date will be here before you know it!
Make the election by including a statement with your 2022 Form 1040 filed by that date or with a Form 4868 extension request for your 2022 return filed by that date.
Passing the Test to Qualify as a Securities Trader
To be classified as a securities trader rather than a garden-variety investor, your trading activities must constitute a business, and you must meet both of the following requirements.
- Your trading must be frequent and substantial.
- You must seek to profit from short-term market swings rather than profit from longer-term strategies.
As stated earlier, there’s no bright-line distinction between trader and investor status. Instead, we must rely on court decisions for guidance. Here is how that goes.
Illuminating Tax Court Decisions
The following are digests of some semi-recent Tax Court decisions that present what we think are well-reasoned analyses of the trader-versus-investor issue.
The 2015 Poppe Decision
The taxpayer, William Poppe, lost over $1 million from trading in 2007. The Tax Court concluded that the taxpayer qualified as a securities trader for that year because he executed about 60 trades per month, devoted four to five hours per day to trading on days when the markets were open, and always traded during the last hour of the day when there is heavier market activity.
He also met the second requirement for trader status by seeking to profit from short-term market swings. His trading was largely in stocks and options that were held for less than one month.
The 2014 Assaderaghi Decision
The taxpayer, Fariborz Assaderaghi, had a regular full-time job as a corporate vice president of engineering. He traded securities on the side.
During 2008 and 2009, his trades included security purchases and sales, put and call options, and short sales. In 2008, he executed trades on 154 days. In 2009, he executed trades on 94 days.
He generally monitored and traded between 20 and 30 different stocks and options. To analyze market trends, he researched nine-day and 26-day market indicators and used technical tools such as stock option pricing, moving average convergence divergence, and exponential moving averages to look for oversold and overbought conditions.
After an audit, the IRS determined that the taxpayer was not a securities trader and that all his trading losses were therefore capital losses. So only $3,000 of the losses could be deducted in 2008 and another $3,000 in 2009. The unhappy taxpayer took his case to the Tax Court.
In earlier decisions, the Tax Court had concluded that making 189, 204, 289, 303, 313, 372, and 535 trades in a year was insufficient to qualify for trader status but that making 1,136 and 1,543 trades were sufficient. In earlier decisions, the Tax Court had also opined that making trades with gross sales proceeds of $754,277 in one year was insufficient to qualify for trader status but making trades that resulted in gross sales proceeds of nearly $15 million was sufficient.
Mr. Assaderaghi executed a total of 535 trades in 2008 and a total of 180 trades in 2009. He had gross proceeds from securities sales of $2,659,696 and $349,991 for those two years.
In earlier Tax Court decisions in which taxpayers had been deemed traders, the number and frequency of their transactions indicated that they were in the market almost daily for substantial and continuous periods and that their trading activities constituted their sole or primary source of income.
In Mr. Assaderaghi’s case, more than half of his 535 trades in 2008 occurred during the three months of January, June, and July; furthermore, he traded on fewer than 10 days in the months of February, August, and October of that year. He traded on a total of 154 days in 2008.
In 2009, he made a total of 180 trades but traded on fewer than 10 days each month from January through June. He traded on a total of 94 days in 2009.
The Tax Court concluded that Mr. Assaderaghi’s trading activities in those two years were not frequent enough or substantial enough for him to qualify as a trader. Next, the Tax Court noted that for a taxpayer to be a trader, the taxpayer must also seek to profit from short-term market movements. According to the Tax Court, Mr. Assaderaghi failed to prove that he passed that test.
Based on the aforementioned considerations, the Tax Court reached the unsurprising conclusion that Mr. Assaderaghi was a garden-variety investor in 2008 and 2009 rather than a securities trader. As such, all his trading losses for those two years were capital losses subject to the $3,000 annual deduction limit.
The 2011 Kay Decision
The taxpayer, Richard Kay, was the sole owner of a profitable S corporation and also traded relatively large dollar volumes of stock during 2000, 2001, and 2002.
In 2000, he bought stocks worth over $20 million and also sold stocks worth over $20 million.
In 2001 and 2002, the dollar volume declined precipitously. His annual purchases were about $2.3 million and $1.2 million, and his annual sales were about $1.6 million and $1.9 million.
The taxpayer’s trading frequency was unimpressive in all three years. The number of days on which he made trades ranged from a high of 73 to a low of 18, and the number of annual transactions ranged from a high of 313 to a low of 72.
As for day trading, which is indicative of trader status, he bought and sold the same stocks on the same day only six times in 2000, four times in 2001, and three times in 2002. After an audit, the IRS disallowed all but $3,000 of his annual net losses from stock trading. The unhappy taxpayer took his case to the Tax Court.
The Tax Court noted that to qualify as a trader, a taxpayer must engage in trading that is substantial enough to constitute a business, and his goal must be to profit from daily price swings rather than profiting from buying and holding stocks for longer periods.
The Tax Court concluded that the taxpayer’s trading activity was substantial in terms of dollar volume. But it was insubstantial in terms of frequency, time spent, and the importance of trading as a significant source of income. So, the Tax Court upheld the government’s disallowance of all but $3,000 of the taxpayer’s annual net losses from stock trading.
Other Tax Court Decisions Cited in Kay
In earlier decisions cited in Kay,11 the Tax Court had opined that engaging in 106, 124, and 289 trades per year was insubstantial, but engaging in 1,100 trades per year was substantial. Making 326 trades with sales proceeds in excess of $9 million was also deemed to be substantial. Moreover, trading on only 45 percent of the days the markets were open was deemed to be insubstantial.
In another decision, the taxpayer’s trading activity was deemed to be insubstantial because it was not a major source of income. On the other hand, in yet another decision, the IRS conceded that the taxpayer, who was a physician, qualified as a trader even though he made his living from being a doctor.
The 2011 Van der Lee Decision
In another 2011 decision, this case involved a former Merrill Lynch trader who left the firm to trade for his own account.
In 2002, he engaged in 159 transactions, none of which were day trades. He deducted approximately $1.4 million in net trading losses. He also deducted approximately $92,000 of trading-related expenses on his 2002 Schedule C.
After an audit, the IRS concluded that the taxpayer did not qualify as a trader and disallowed all but $3,000 of his trading losses and all of his Schedule C trading-related deductions. The unhappy taxpayer went to the Tax Court seeking justice but found no sympathy there.
The Tax Court opined that making only 159 trades in 2002 was insubstantial, despite the fact that substantial dollars were involved. Therefore, the Tax Court agreed with the IRS that the taxpayer did not qualify as a securities trader and that all of his trading losses in excess of $3,000 were properly disallowed along with all of his claimed Schedule C deductions.
If You’re a Trader, Congratulations—but Segregate Any Longer-Term
Let’s assume that you can make the case that you’re a securities trader.
That’s great, but note that after making the mark-to-market election, you cannot take advantage of the preferential
federal income tax rates on long-term capital gains for securities held in your trading portfolio.
Key point. That should not be a problem. As a trader, you should not be holding anything but short-term bets in your trading portfolio anyway.
But here’s the deal. You can be both a trader and an investor. Therefore, long-term gains from your investment portfolio (as opposed to your trading portfolio) can still qualify for the lower capital gains tax rates. To occupy this
“best of both worlds” scenario, your records must clearly identify investment holdings (as opposed to trader holdings) as such on the day they are acquired.
Advice. In case you ever get audited, keep things transparent by holding your investment portfolio and your trading portfolio in separate brokerage firm accounts.
No matter what, if you hold substantially similar securities for both trading and investment purposes, you must keep the similar investment securities in a separate non-trading account if you want to benefit from lower tax rates on long-term gains from the similar securities held for investment.
Recent stock market volatility highlights the question of whether you can qualify for tax-favored securities trader status. If you’ve read this far, maybe you can!
- Traders can deduct their trading-related expenses on Schedule C.
- Traders are eligible for the tax-saving mark-to-market election.
The issue of who qualifies as a trader is blurry, but the Tax Court decisions summarized in this article provide some useful guidance.
Finally, if you qualify for trader status, don’t forget the counterintuitive, rapidly upcoming deadline for making a mark-to-market election for your 2023 tax year.