What’s Your Strategy: Short-Term or Long-Term Investing?
Trader vs. Investor
Taxpayers who buy and sell securities generally will qualify as either an investor or a trader for tax purposes. The distinction between trader and investor is important because tax rules are generally more favorable for traders. As a general rule, most taxpayers are categorized as investors. However, some taxpayers are spending considerable time trading stocks on a regular basis, which may qualify them for trader tax status.
To qualify as a trader, an individual must be active in the securities markets on a daily basis and attempt to profit from short term swings in security prices.
In determining whether a taxpayer is a Trader or an Investor, tax courts consider the following factors:
- The taxpayer’s investment intent
- The nature of the income to be derived from the activity
- The frequency, extent, and regularity of the taxpayer’s securities transactions
Mark-to-Market IRC 475 (f) Election
There are three different classifications for taxpayers who trade securities:
- Traders subject to mark-to market accounting under Internal Revenue Code §475(f).
In general, the main distinction in tax treatment between traders and investors relate to how to categorize the deduction of the related investment expenses. Investors’ expenses are deductible only as itemized deductions and are subject to deductibility limitations based adjusted gross income. Traders’ expenses are deductible in arriving at adjusted gross income as ordinary business expenses and are not are not subject to further adjusted gross income limitations. Traders subject to mark-to-market under IRC§ 475(f) must treat all securities related to trading activities as inventory and all income and losses (realized and unrealized) are treated as ordinary income instead of capital.
Investors treat stock holdings as capital assets and report gain or losses as capital, depending on whether shares were held for more than one year. The expenses incurred in connection with investing activity are treated as expenses incurred for the production of income. These expenses are deductible as miscellaneous itemized subject to the two percent of adjusted gross income limitation.
Trader Tax Status (TTS)
The classification of a taxpayer as a trader is a purely judicial phenomenon, but it carries with it a number of tax advantages and few, if any, disadvantages. Unlike investors, securities traders are deemed to be conducting a “trade or business”, so trading expenses are deductible as ordinary and necessary expenses. A trader’s business expenses include interest paid on margin accounts used in connection with the trading activity.
However, if the taxpayer does not materially participate in the trading activity (e.g., a limited partner in a trader partnership), interest incurred in the activity is subject to the investment interest expense limitation. Individuals who are traders report trading expenses on Schedule C and, therefore, eligible for a greater benefit by being able to deduct these costs when computing AGI. Despite all these tax advantages resulting from being a self-employed trader, the taxpayer still generates capital gains and losses and is exempt from self-employment (SE) taxes.
Traders Subject to Mark-to-Market Election
IRC §475(f) allows traders to elect to mark their stock holdings to market at the end of the tax year. If the election is made, any gains or losses with respect to such securities, whether deemed sold at year-end under the mark-to-market method of accounting or actually sold during the taxable year, shall be treated as ordinary income or loss. All security gains and losses are treated as ordinary income or loss. A primary benefit of making the election to be treated as subject to mark to market is that the annual $3,000 limitation on net capital losses will not apply. Traders who choose to make the mark-to-market election must follow the rules set forth in Revenue Procedures 99-17, 2008-52 and 2009-39 which include attaching certain elections and specific forms choosing this method of accounting.
A §475 mark-to-market election converting the capital gains and losses to ordinary income does not change their status for SE purposes. However, since a trader’s net earnings are not SE income, he cannot contribute to a retirement plan (e.g., SEP or IRA) based on such income. Although a trader’s security gains and losses are excluded from SE earnings. Since these taxpayers elect to treat all their income (realized and unrealized) as ordinary income, there is no need to test at year end for wash sales, constructive sales, and straddles. The absence of this requirement not only significantly reduces an administrative burden on the taxpayer, but also can potentially reduce taxpayer’s professional fees.
Most Investors Can't Qualify as Traders
The concept of a “trade or business” is not defined in the Internal Revenue Code, but is judicially developed. According to the Tax Court, the distinction between a trader and an investor is that a trader buys and sells securities with reasonable frequency in an effort to catch the swings in the daily market movements, and profits on a short-term basis. Taxpayers whose time and effort are devoted to securities transactions and are substantial should always consider attempting to achieve trader status. Most investors cannot qualify as traders, but many can.
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