February 03, 2021
Do you spend part of your free time day trading? Or have you become so successful and well versed at day trading that it’s become your sole source of income? No matter which category you fall into, you need to make sure that you’re filing your taxes properly. Otherwise, you could be surprised by fines and fees, find yourself being audited, or end up in major trouble with the IRS for misreporting your income and losses. Here are some of the things that you need to watch out for when reporting your day trading income on your tax return.
What Is Day Trading?
In the past, trading on the stock market was something that could only be done by Wall Street firms and those of a similar nature, such as hedge funds. The average person – albeit one who could afford to play the stock market – could not. Now, things have changed, and anyone with the money, time, and financial knowledge can spend part of all of their time day trading. Thanks to the internet and the many companies that created software that makes it easier to do this type of investing, day trading is entirely possible for many people.
Do You Have a Trader Tax Designation?
If you’re planning to file a tax return as a day trader, then you’d better make sure that you have that designation in the eyes of IRS first. Someone who makes the occasional trade here and there may not qualify as a day trader, as they won’t meet the criteria.
Here are some of the qualifications you need for the trader tax designation:
- You make a substantial number of trades over the course of the year. – While the IRS doesn’t define what they mean by “substantial,” one number that you can use to gauge your trading activities is the number of them that you make each day. Generally, anything over four per day or 60 per month is enough to qualify.
- Your goal is to make a profit from your trading activities. – This one seems obvious, but there are people who simply want to experiment with day trading and get their feet wet. If you are just testing the waters, you won’t make the number of traders per day or month required to qualify. Those who intend to make a profit will definitely trade stocks, bonds, securities, and so on a daily basis.
- You make trades on a regular basis and will continue to do so in the future. – People who aren’t serious about becoming a day trader will only experiment with them for a short period of time. Once they lose a substantial amount of money or have met their goals of trading only a certain number of securities, they will stop. Serious day traders will keep up their trading for years to come, and some may even see it as a business.
- You don’t hold onto the securities or stocks for a long period of time. – Investors tend to hold onto their stocks, bonds, and securities. They want to see how the market will change with the goal of selling when the price gets high and buying when it dips down low. Day traders, on the other hand, have a goal of making a lot of different moves on a daily basis. This means that they rarely hold onto a purchase for more than 30 days.
- You have a business set up for your trading. – Every qualified day trader must have a business under their name that they use for their trading and tax reporting activities. They can use this business to purchase small business software and other necessities, even if they operate out of a home office instead of an outside business location. This is viewed by the IRS as a sign that they are serious about the practice and will continue day trading.
There are a number of other criteria that day traders need to meet, such has a minimum amount of account equity, as well as some exceptions to these rules. If you have questions about whether or not you qualify for the day trader tax designation, contact a professional tax expert.
What If You Don’t Have a Trader Tax Designation?
Those without a trader tax designation are considered to be investors, according to the IRS. This means that they are not eligible for many of the write-offs and other things that a day trader can use to offset the amount of money that they make through their trades each year. For example, a day trader can deduct things like losses, as well as other write-offs like business expenses. An investor often cannot, and any money made either counts as ordinary income or falls subject to capital gains taxes. Including these things on your tax return, if you do not qualify for them, can result in fines, audits, and other penalties.
Loss Deductions and Tax Write-Offs
Day traders qualify for a number of different tax deductions and write-offs. Some of the most common ones include:
Wash Sales – Sometimes, a day trader will sell a certain stock at a loss, losing money on the sale. They do this in order to deduct the amount that they lost on their taxes. However, in order for a wash sale to work properly, in the eyes of the IRS, the trader must purchase a similar stock (in some cases, the exact same one) within 30 days of the sale. In some cases, if they have purchased a similar stock 30 days before that sale, it counts as well. Anyone other than a day trader who attempts to do this, even if it’s a business or related entity, will find themselves in trouble. However, day traders are an exemption to the rule. It doesn’t apply to them, so they can make these trades and deduct their losses on their tax returns.
Deducting Expenses – There are plenty of expenses that go along with operating as a day trader. Those who run it like a business have plenty of overhead, from rent and utilities to necessary purchases, such as computers, printers, software, and so on. In order to deduct these expenses from their income on their tax returns, day traders must have the correct designation and be operating under a small business name and tax ID. Loan interest and other things may be deducted as well. This allows day traders to offset some of the money that they make trading by investing their business to become better at their jobs. For example, software that analyzes the market, as well as the costs of industry publications, can be included in these deductions.
Mark to Market Accounting – For day traders who are worried about having to pay taxes on a large amount of the money that they made over the past year, mark to market accounting actually puts them within the range of a standard salary. How does this work? Day traders are allowed to report their annual gains and losses at the end of year, making it seem as though they sold everything. They don’t have to adhere to the $3,000 limit in net losses that the average taxpayer does. Using this tactic makes a day trader’s income subject to short term capital gains, but they can offset this with their losses.
If you qualify for a day trader tax designation or have plenty of questions about the process before filing your return with the IRS, please reach out to the tax advisors at Enterprise Consultants Group. We can answer your questions, discuss your rights, and provide actionable options. Please contact us online or at (800) 575-9284 today to schedule a free and confidential consultation to see how we can help you.
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