Tuesday, December 7, 2010

Trader vs. Investor: It Matters for Taxes

Preface: I'm a CPA, but consult your own tax advisor before doing anything.  The post is long, but I wanted to get all the info out there. I may break it up in the future.

If you are involved in the markets, you are classified as either an investor or a trader for tax purposes.  The difference between a trader or an investor is a significant one. Generally speaking, most people are classified as investors. I will attempt to explain the difference between a trader and investor, including the tax implications that follow.

INVESTORS

Investors have stock holdings, and when they are sold, report either long-term [LTCG] or short-term capital gains [STCG] and losses, depending on whether the shares were held for more than one year. STCG's are taxed at ordinary income rates, which can be as high as 35%. LTCG's are taxed at 15%, but if your overall income is below a certain threshold, they could be as low as 0%. (As of writing, it looks like Obama extended this for 2 more years.)

Investor Expenses

Investment expenses: Items such as a management fee paid to your advisor or investment subscriptions (IBD, WSJ), are deducted as itemized deductions. But they are not treated like normal itemized deductions (i.e. mortgage interest, property taxes, charity). They are only deducted as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) limitation. This is not favorable.

Example: Your AGI is $100,000. 2% of $100K is $2,000. If you paid $2,500 to your advisor, your deduction is calculated at only $500 [$2,500 minus $2,000]. If you had $1,500 in expenses, you don't even get a deduction after factoring the 2% limitation.  As you can see, there is not a lot of bang for your buck on these "2% miscellaneous itemized deductions."

More bad news: 2% miscellaneous itemized deductions are added back for Alternative Minimum Tax (AMT) purposes. It basically means that these don't count as regular deductions. They're added back on your AMT schedule [Form 6251] and could cause you to pay AMT. 

Note: In order to get this deduction: 1) pass the 2% hurdle 2) not be subject to AMT. Many investors receive little or no tax benefit because of these reasons.

Commissions:  Any commissions paid while buying stock are capitalized as part of its cost basis while commissions paid at the time of sale are treated a selling expenses, thus reducing sales proceeds. These go on your Schedule D and go into the calculation of whether you have a gain or loss on your stock sales.

Interest:  Investment interest expense is deductible only to the extent of the taxpayer’s net investment income [dividends, capital gains, interest minus investment expenses]. So if you paid $2,000 margin interest and had $2,000 capital gains and $500 deductible investment expenses, your net investment income is $1,500. You only get a $1,500 investment interest deduction. The good part is that the unused $500 is carried forward indefinitely, allowing you to use it in the future as long as you have net investment income.

TRADERS

Trader Expenses
Unlike investors, traders are deemed to be conducting a trade or business, so their trading expenses are deductible as ordinary and necessary business expenses, reported on Schedule C. The expenses are fully deductible and not subject to the limitations described above. No 2% limitation and no net investment income limitation on your interest expense.

In addition, traders are eligible for the home office deduction. Take the square footage of your home office divided by the square footage of your home and you have your home office %. All regular expenses related to your home are deductible according to the calculated %. Interest, property taxes, utilities, cleaning, even HOA dues are eligible for a deduction based on that %. Beware, there are lots of rules and qualifications. I would take real measurements (no eyeballing it) and a picture of the office. Learn more here

Two Kinds of Traders: Those with the Sec. 475 Mark-to-market Election and those without.

Without: your gains and losses are capital in nature. They are treated the same as if you were classified as an investor. Good: Long term gains get the favorable long term rates. Bad: Losses are limited to $3,000 per year.
With: IRC Sec. 475 allows traders to elect to mark their stock holdings to market at the end of the tax year. What does this mean?

All gains and losses are treated as ordinary income and all positions on hand at year-end are deemed to be sold at the year-end market value, thus recognizing unrealized gains and losses. For traders, the primary benefit of making the election is that they are not subject to the $3,000 capital loss limitation and the wash sale rules no longer apply. But you do need to give something up: you can't treat your trading gains and losses as capital asset transactions. This means no LTCG rates. This shouldn't really matter though because traders by definition should have few, if any, LTCG's.

Traders who choose to make the mark-to-market election must follow the exclusive procedures set forth by the IRS. Existing taxpayers must (1) attach an election statement on your return and (2) attach a completed Form 3115 “Application for Change in Accounting Method” to their return for the
year of change, The election is effective for the first year for which it is made and all subsequent tax years, unless revoked with the consent of the IRS.

Mark-to-market is complicated and weird. Consult your tax advisor! Especially if you're normally a Turbo-Taxer.

Reporting Issues for Traders

1. Schedule C Loss. Traders report no income and only expenses on Schedule C, resulting in a loss on that form. The IRS doesn't like seeing negative numbers year after year. They will question whether you actually have a business. They will try to say it is a hobby and subject to a bunch of unfavorable rules. Be ready.

Idea: Attach a statement to your return explaining your trader status and the filing implications that go with it. It's better than attaching nothing and further establishes your reporting intent.

2. Reconciling to Forms 1099-B. This is the form that reports your gross sales proceeds. The IRS has a computerized matching system. If your schedule D gross proceeds do not reconcile to the 1099-B's they have, you will most likely get a notice. If you have mark-to-market status, you'll be reporting your activity on Form 4797, not Sch. D. The IRS gets confused by this.

Idea: If you've made the Sec. 475 election, put a line item on your Sch. D showing your gross proceeds from all Form 1099'B's, with an equaling offsetting amount for basis. Use a description like "see Form 4797 for trading details." No gains or losses are reported on Sch. D and the IRS should get what's going on.

Self-Employment Tax

Most folks who normally report their business income on Schedule C, are required to pay SE tax. SE tax is payroll tax, also known as FICA: social security 6.2% and Medicare 1.45%. That is a total of 7.65%, but since you're self employed, you need to pay the employer and employee portions. You would actually pay 15.3%. This is crappy but all you need to know is that SE tax does NOT apply to traders or investors.


SUMMARY OF TAX RULES FOR TRADERS AND INVESTORS
Description
Investor 
Trader
Mark-to-Market Trader
Gains and losses 
Capital (Sch. D) 
Capital (Sch. D) 
Ordinary (Form 4797)
Interest expense 
Investment interest expense 
Trade or business expense 
Trade or business expense 
Trading expenses 
Misc. itemized deductions subject to 2% AGI limitation (Sch. A) 
Trade or business expenses (Sch. C) 
Trade or business expense (Sch. C) 
SE tax 
Not applicable 
Not applicable 
Not applicable 



Distinguishing Traders from Investors

The IRS hasn't issued official guidelines on this matter. But it is safe to assume that taxpayers are classified as investors unless they demonstrate that are carrying out a trading business.

Even though the IRS hasn't issued anything, the courts have provided us with some factors to consider. 1) investment intent 2) nature of the income 3) frequency and extent of the trading activity. You are most likely are trader if the next two statement apply to you. 1) Your trading activity is substantial 2) You attempt to profit from short-term swings in the daily movement of the market, rather than profit from the long-term holding of investments.

The following is a helpful, but not all-inclusive, guide.


CHARACTERISTICS OF TRADERS AND INVESTORS
Description
Investor 
Trader
Buying Criteria
Long term approach. Dividends and fundamentals are prominent factors
Look to exploit short term price swings. Select stocks based more on technical analysis.
Involvement
Weekends or after work. You have other primary sources of income. May rely on broker.
Substantial, regular, continuous and frequent. Trading is primary source of income.
Holding Periods
Long and Short term
Usually less than 30 days. Rarely any long term holds
Frequency of trades
Sporadic, no pattern. Long periods with no trades

Average 1 or more trades daily. Few periods without activity
Source of income
Long term gains, interest & dividends
Short term


Footnotes


This written advice is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer by any governmental taxing authority or agency. Unless otherwise stated, any views or opinions contained in this blog are that of the writer. Trader CTC furthermore disclaims liability for any unauthorized opinion or representation made by any sender purportedly on behalf of Trader CTC .

4 comments:

Anonymous said...

Excellent

Dr. Jonathan Brown said...

Excellent article. I found this while helping a student to search for "the consequences of trader status". This article has given me in dept knowledge about the differences between traders and investors especially in relation to accounting and tax. Thanks.

Mike said...
This comment has been removed by the author.
Mike said...

Indeed, well written post on trader vs investor. You did amazing job. Beginner as well as expert will really love to read your post. Great work. Keep it up!!
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