The recent GameStop short-squeeze episode provided some eye-opening drama. It also brings attention to the question of who is eligible for the favorable federal income tax treatment that’s available to individuals who trade stocks with sufficient intensity to qualify as securities traders for tax purposes.
Less-favorable tax treatment applies to individuals who actively trade stocks, but with insufficient enthusiasm to be classified as anything other than garden-variety investors with short attention spans.
In my next column, I’ll cover what it takes to qualify as a securities trader under the tax rules. This column is devoted to why it matters. Here goes.
Tax advantages of trader status
Achieving trader status confers more tax advantages than simple active investor-hood. Of course, it also comes with the inherent financial risks of being a trader. In this column, I’ll go into more detail on what it takes to meet the tax-law definition of a “trader” and what happens if you do.
Deduct expenses on Schedule C and enjoy self-employment tax exemption
Let’s assume you qualify as a securities trader for tax purposes. The IRS now considers you to be in the business of buying and selling stocks for a profit. You are therefore entitled to fully deduct your trader-related expenses on Schedule C of Form 1040 just like any other sole proprietor. However, unlike most sole proprietors, you don’t have to pay the dreaded self-employment (SE) tax on your net profit from trading. That’s great, but there’s more.
Make the mark-to-market election
Once you are classified as a trader for tax purposes, you become eligible to make the special “mark-to-market” election. If you make the election two important tax benefits come your way.
- First, you don’t have to worry about the dreaded wash-sale rule, which defers your tax loss when you buy the same stock within 30 days before or after a loss sale. If you make lots of trades, this can happen all the time. The disallowed wash sale loss gets added to the basis of the shares that caused the problem. But with the mark-to-market election you won’t have to spend any time on bookkeeping to comply with the wash sale rule. You can spend all your time researching and trading stocks. Good.
- You are also exempt from the dreaded $3,000 annual limit on deducting net capital losses ($1,500 if you use married filing separate status). That’s because as a mark-to-market trader, all your trading gains and losses are considered “ordinary” gains and losses just like garden-variety business income and expenses. If you have bad year, you can fully deduct your net trading loss when you would otherwise be limited to a mere $3,000 (or $1,500) write-off. Good.
The price to be paid
If you make the mark-to-market election, must pretend to sell your entire trading portfolio at market on the last trading day of the year and include all the resulting tax gains and losses on your Form 1040. If you have an overall gain, your tax bill goes up accordingly.
Next, you must pretend to buy everything that you pretended to sell at year-end back at the same price. So, stocks in your trading portfolio will start off the new year with tax basis equal to market value and no unrealized gains or losses. That’s the mark-to-market concept in action. However, if you empty out your trading portfolio at the end of the year, or nearly so, this mark-to-market stuff is either N/A or relatively inconsequential.
For gains from stocks held in your trading portfolio, you can’t benefit from the preferential 15% or 20% federal income-tax rates on net long-term capital gains However, this really isn’t a problem because you shouldn’t have anything but short-timers in your trading stable anyway. See below regarding segregating your non-trading investments in a separate account.
Mind the mark-to-market election deadline
Unfortunately, many folks who can qualify as traders already missed the chance to make the mark-to-market election for 2020. And you’ll miss out for 2021 as well if you’re not careful. Here’s why. According to IRS Revenue Procedure 99-17, you must have made the election for the 2020 tax year by attaching an election statement to your 2019 return filed by 7/15/20 or to an extension request (Form 4868) for your 2020 return filed by that date.
To make the election for your 2021 tax year, you must attach an election statement to your 2020 return filed by just-changed deadline of 5/17/21 or to a request to extend the filing deadline for your 2020 return (Form 4868) filed by that date. See here.
The bottom line
Many traders won’t be able to take advantage of the mark-to-market rules until the 2021 tax year at the earliest. If you fit into this category, write a note to yourself to attach an election statement for the 2021 tax year to your 2020 return filed by 4/15/21 or to a request to extend your 2020 return (Form 4868) filed by that date. Your tax pro can help you do what it takes to make the election for your 2021 tax year.
One more thing
If you were not properly classified as a securities trader for the tax year before the year your mark-to-market election takes effect, making the election counts as an “accounting-method change.” That requires filling out IRS Form 3115 (a complicated sucker previously known only to seasoned tax pros). For example, say you qualified as a trader in 2020 and make the mark-to-market election for your 2021 tax year (don’t forget the 5/17/21 deadline). You’ll have to deal with Form 3115 when you prepare your 2021 return sometime in next year. You may want professional assistance with that.
How traders should handle stock gains and losses
If you are a trader who has not made the mark-to-market election, your capital gains and losses from trading go on Form 8949 and Schedule D, the same as gains and losses from regular investing activity. Your trading expenses go on Schedule C, which means you’ll automatically show a loss on that form, because it does not include any revenue from your trading efforts. That could make the IRS nervous, so you attach a statement to Schedule C explaining that the revenue side of your trading business is shown on Schedule D. The statement should also quantify your net trading gain. At least we hope there’s a gain, and we hope it’s more than enough to offset your trading expenses.
If you’ve made the mark-to-market election, report all your trading gains and losses on Part II of IRS Form 4797 (Sales of Business Property). Then attach a statement to Schedule C to explain that the revenue side of your trading business is shown on Form 4797.
Segregate your non-trading investments
You can be both a securities trader and an investor at the same time. So, long-term gains from your non-trading portfolio will still qualify for that nice 15% or 20% federal income-tax rate without diminishing the tax benefits available for your trading activity.
To occupy this “best-of-both-worlds” scenario, your records must clearly identify non-trading investments as such on the day you buy them. Also, the IRS says you must keep investment stocks and trading stocks in separate brokerage accounts if you’re investing in and trading the same issues. In any case, please take my advice and just use separate accounts. That will make things easier for the IRS to understand if you ever get audited.
The last word
You now understand the federal income tax advantages of securities trader status. But we have not yet covered how to decide if you qualify as a trader. My next column will be devoted to answering that question. Please stay tuned.