Like it or not, we all have to pay taxes.
That alone can be stressful, but day traders have much more to consider than the average person. If you’re a trader, you don’t get to just enter your W-2 into some tax software, sit back, and wait for the results.
There’s way more at play when filing your taxes as a day trader. You probably already know that you have to pay taxes on your trading income, but what are the details? What deductions can you make, if any?
Don’t worry: I’m gonna cover all that stuff. Day trading taxes don’t need to be difficult. It’s just like anything else … You gotta familiarize yourself with the process. It’s all part of your trading education.
But before we get to the nitty-gritty, my lawyers would have my head if I didn’t say this first: This communication doesn’t establish a professional relationship for accountancy, tax advice, legal or any other professional service. Any information presented in our communication with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) regarding any issues should not be construed as advice as it pertains to tax matters, legal matters, or any other matters. Always consult the advice of a professional licensed in your state or jurisdiction before making decisions on tax or legal matters.
OK, that’s out of the way now, so let’s do this!
Table of Contents
- 1 Before We Get Started: Know These Terms
- 2 Tax Day: The Basics
- 3 Trader or Investor: Know the Difference
- 4 Trading Challenge
Before We Get Started: Know These Terms
There are a few basic terms you need to know off the bat. You’ll probably see these when you’re filing your taxes, so you should understand what they mean.
If you made any money this year from buying and selling securities — which you hopefully have — then those profits are your capital gains.
Capital gains are taxable income and you have to report it as such. Pretty simple.
I think you can probably figure this one out. Capital losses are the opposite of capital gains.
When you lose money from buying or selling a security, that’s a capital loss.
Capital losses are actually deductible. But, depending on your tax status, the amount that you can deduct is limited (more on that in a bit).
Your cost basis is the value used to measure profit and loss. It’s the amount that you pay (including commissions) for a security.
If you close your position at a value higher than your cost basis, it contributes to your capital gains. The opposite is a capital loss.
Earned income does NOT include income from trading. It only counts income made from full-time or part-time jobs, including your salary, hourly wage, tips, bonuses … well, you get the idea.
Since trading income isn’t ‘earned’ income, you don’t have to pay self-employment taxes. Yes, that can save you some money. But if you don’t pay those taxes, you also aren’t contributing to social security. You have to do that to qualify for retirement benefits.
Dividends, interest, royalties, annuities, etc. — any money you make from property held for investments before deductions is investment income.
Capital gains can count toward your investment income, but only if you choose to include it.
The Wash-Sale Rule
The IRS created the wash-sale rule to prohibit traders from claiming a loss on the sale of a security in a wash-sale.
So, what’s a wash-sale? That’s when you trade a security at a loss, and then, within 30 days before or after the sale, you purchase what the IRS calls a “substantially identical” security.
The good news here is that there’s a special exception for this rule, so stay tuned for that.
Tax Day: The Basics
OK! We made it through the tedious stuff. Now let’s talk about filing taxes.
For the most part, it isn’t too complicated. Especially if you aren’t classified as a trader with the IRS.
There are a few things you might not know, including some benefits that you might qualify for. Let’s get to it.
Long-Term vs. Short-Term Investments
Different types of investments are taxed at different rates.
Short-term investments are positions that you held for less than a year. These are taxed at the normal income rate. So, for example, the short-term income tax rate for gross annual income between $37,951 to $91,900 would be 25%.
Long-term investments are any positions that you held for over a year. Using the same income range from above, the long-term tax rate would be 15%.
Keep Separate Accounts
There are plenty of reasons you should separate your long-term investments from your short-term investments.
First of all, it’s just easier. For accounting purposes especially, it can make your life simpler. Beyond that, the IRS requires traders to divide their long-term and short-term investments into different brokerage accounts when trading the same issues.
Lastly, you wanna make sure you classify as a trader with the IRS. Combining your investments could disqualify you from getting this designation, and you’d likely miss those tax benefits if you didn’t get ‘em.
And again with the lawyers! IRS CIRCULAR 230 NOTICE. Nothing in our communications with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) relating to any federal tax transaction or matter are considered to be “covered opinions” as described in Circular 230.
Pardon yet another legalese interruption. I love my lawyers. I can’t imagine being a lawyer. Just reading the short disclaimer above made me drowsy. I’d probably never get much done if I were a lawyer because I’d be falling asleep all the time.
OK, let’s keep going with the tax stuff. Yeah, that’s boring too, but we’ve all gotta deal with taxes, so grit your teeth and keep reading. The lawyers say they won’t interrupt anymore for the rest of this post, so it’s home-sprint time. Let’s go!
Capital Gains & Capital Losses
We already talked about what these terms mean, so we don’t need to cover it again.
What we do need is to learn how to report your capital gains and losses on your taxes. It’s not as straightforward as you might think … and it involves a few different forms.
Which forms you need depends on whether you made the mark-to-market election last year (I’ll talk about that more in a sec).
Trading expenses go on Schedule C. This form doesn’t reflect your revenue, so it looks like you’re only reporting a loss. To fix this, it’s recommended that you include a statement indicating that your net trading gains are shown on Schedule D.
Trader or Investor: Know the Difference
The IRS sees everyone who trades as either a trader or investor.
You might not think it’s an important distinction, but people who qualify as traders can save some serious money on tax day.
Are You a Trader?
How do you know if you qualify for these tax benefits? Well, that’s the tricky part.
The IRS couldn’t be more vague in its explanation of the requirements. The IRS says your trading activity has to be substantial and consistent. And that’s as specific as it gets.
You can probably see why this presents some problems. Taxes are serious business — you don’t want to make any false assumptions.
In any case, there’ve been several court cases on the topic, which gives us a better idea of what it means to qualify as a trader.
Substantial, Constant Activity
The primary requirement is that you spend a lot of time trading and that you do so consistently.
Again, there’s no set amount of hours or anything, but the more, the better. If you don’t have a job and you trade full-time, that definitely helps. It’s harder to argue that you aren’t a trader if that’s how you make a living.
You can also be a part-time trader, but you should be making several trades on a daily basis in that case.
Your trading also shouldn’t be sporadic, like one day here and there. You can take occasional breaks, but, for the most part, you should make several transactions per day throughout the year.
Did You Make a Profit?
Turning a profit might not be a requirement, but can help make your case.
An important thing to remember is that the IRS treats traders the same way it treats businesses. As far as businesses go, tax law says that they should typically be profitable for three years in a five-year period.
Again, this may not be the deal breaker. Maybe you haven’t even been trading long enough to meet this requirement, but it’s definitely not gonna hurt.
Can You Be a Trader and an Investor?
Short answer: Yes.
Longer answer: Yes, but with a caveat.
To be classified as a trader, your goal should be to profit from short-term market movements. Investors make money from dividends and long-term gains. If you hold several long positions, it can weaken your case as a trader.
To be both a trader and investor, you should separate your long-term positions. That means you identify them as such in your records on the day you purchase them.
If you meet all of these criteria, there’s a good chance you qualify as a trader. If so, congratulations, you just might save some cash.
Schedule C Deductions
Bonus for those of you who qualify as a trader: The IRS sees traders as self-employed buyers and sellers of securities.
Just like any other sole proprietor, you can deduct your trading-related expenses on Schedule C.
These deductions will also reduce your adjusted gross income. This means you could potentially qualify for more tax breaks.
One of the great things about achieving trader status: the mark-to-market election.
Again, if this is your first year filing taxes as a trader, this probably doesn’t apply to you. But keep reading — you might be able to reap the benefits next April.
Here’s how it works: On the last trading day of the year, you have to pretend to sell and repurchase your entire portfolio. You record your imaginary gains and losses, which allows you to start the new trading year with no unrealized gains or losses.
The mark-to-market election has some great advantages.
First, you’re exempt from the wash-sale rule. This can save you a ton of bookkeeping trouble. And that frees up time that you can then spend focusing on trading.
Next, remember how I mentioned earlier that the amount you can deduct in capital losses depends on your tax status …
Most people can only deduct up to $3,000 in net capital losses each year. This limit doesn’t apply to mark-to-market traders. Mark-to-market traders can deduct an unlimited amount of capital losses.
You might not like to think that you’ll lose enough for this to matter, but it happens all the time. In a bad year, this might help undo some of the damage.
Forms for Mark-to-Market Traders
As a mark-to-market trader, the IRS allows you to report all of your capital gains and capital losses as business property. You should do this on Part II of IRS Form 4797.
Maybe you had a down year and you’re ready to revamp your strategy. Maybe you want to learn how to make the jump from casual investor to full-time trader. The new tax year is a great time to start.
No matter your situation, you need to continue to learn new trading strategies, how to analyze the markets, and how to minimize your risk. Intimidating? Sure. Impossible? Absolutely not!
I’ve been trading for decades — and I’m completely self-taught. Now I take what I’ve learned throughout the years to teach others how they can prepare to enter the markets.
If you’re ready to really dive into the world of trading, join my Trading Challenge. No matter your experience level, my Trading Challenge is designed to help you develop new strategies, manage risk, and become the smartest trader you can be.
Ready to jump in? Apply for the Trading Challenge today.
This guide contains a lot of the information you need to prepare for tax day. But everyone has different financial circumstances that can affect how they need to file their taxes. Don’t wait for a second to get professional guidance on your particular situation.
It’s important to get taxes right. No one likes to be on the wrong end of IRS scrutiny … Do your research, talk to a professional, and maintain clear records to help you prepare for tax day.
What’s your plan for the new tax year? What are your strategies to make this year better than the last? Let me know — leave a comment!