Updated May 25, 2021
If you buy and sell securities as a primary source of income, you might be hoping to qualify for trader tax status (TTS). Filing taxes under this designation provides day traders with a number of benefits, such as writing off losses, business expenses, and employee benefit deductions for retirement plans.
How to Qualify for Trader Tax Status
- Trade substantially, regularly, frequently and continuously
- Seek to profit from short-term price swings of securities
- Have the intention to trade as a business
Someone involved in trading securities is said to be a day trader. They do not need to be a qualified trader by any agency to designate themselves as such (although if they’re managing the money of other people, say through a hedge fund, they do need to be licensed). A day trader just needs to be someone who buys and sells securities for trading gains, either to supplement their ordinary income or as the entirety of their income. Presumably, an individual would only continue trading securities if they saw net gains comparable to or surpassing the ordinary income of earning a salary or some other form of self-employment.
That said, day traders follow the daily market movements of the stock market in search of long term capital gain. Even if their net gains are not ordinary income, they are still taxable. Oftentimes, investments with capital appreciation will be subject to a capital gain tax (unless of course, it resulted in a capital loss). Wouldn’t it be nice if trading stocks could be considered a trading business for tax purposes? And if business expenses could be written off, thus giving tax breaks to said trading business?
Well the good news is that they can with trader tax status. Unfortunately, however, trader tax status cannot be elected by the trader or their tax professional. The IRS will have to acknowledge, in writing, that this taxpayer is a day trader for tax purposes, who can reap the tax benefits of the mark to market election made available to such eligible taxpayers.
What is Trader Tax Status?
Trader tax status comes with a number of benefits, including the ability to deduct interest as an expense. Traders can deduct educational expenses, like stock trading seminars and educational materials, provided that these expenses are itemized and exceed two percent of their adjusted gross income. If a trader works from home, they can take a home office deduction. All of these deductions are listed on their Schedule-C.
Trader tax atatus also allows day traders to make an election for something called mark to market. A day trader who does not have trader tax status can only write off up to $3,000 in trading losses when they file taxes, but those with mark to market election can claim greater losses, if applicable. Mark to market election also eliminates application of the wash sale rule.
A wash sale involves selling a security at a loss and then repurchasing it or a very similar security. The purpose of this sale is usually to claim the loss as a tax deduction and then repurchase the security. Traders usually perform this transaction at the end of the calendar year. The wash sale rule prevents these traders from claiming the loss on their tax return, but it doesn’t apply to traders with trader tax status and mark to market election.
How to Qualify for Trader Tax Status
Trade substantially, regularly, frequently and continuously
You might be wondering how the IRS defines substantially, regularly, frequently and continuously. Truth be told, the definitions are somewhat fluid, but here are some general tips:
If a trader spends at least four hours a day almost every market day (that is, days the stock market is open) making trades, they can be considered a part time or full time trader. This doesn’t just include hitting the buy or sell button. It includes research, administration, and even traveling to meetings. A full time trader is allowed to have sporadic lapses in trading activity for vacations, holidays, and potential illness, but no more than a few (just like anyone who would be employed or self-employed).
The trader must execute trades around 75 percent of the week, which generally means four out of five market days. In some cases, a trader who wants to hold on to trader tax status might find themselves placing small meaningless trades just to retain this requirement. The majority of their trades should be day trades or swing trades no longer than one month.
Seek to profit from short-term price swings of securities
One landmark court case in determining how many trades a day trader must make annually in order to obtain trader tax status was William F. Poppe vs. the Commissioner of the IRS. It was decided that Poppe could indeed claim trader tax status for (among other things) making around 60 trades per month. This kind of trading activity indicates that a trader intends to benefit from the short-term price swings of securities by buying and selling stocks.
Traders must also have at least $25,000 on deposit with a broker in the United States, which gives them the right to title themselves a pattern day trader (as the name implies, someone who hopes to capitalize on daily market movements). This type of trader, with serious cash invested in the markets and placing trades frequently, is clearing trading for profit and not just for fun.
Have the intention to trade as a business
The trader in question needs to have the intention of running a business or making a living. It does not have to be their exclusive means of making a living, but it does need to involve using their own money (not someone else’s money) as the trading material.
Making day trades from your phone may not be considered enough because day traders tend to have some serious equipment: multiple monitors, cloud services, subscriptions, and an office to house it all. They may even subscribe to expensive proprietary software to analyze the stock market numbers. These tools of the trade indicate that an investor is serious.
How to File for Trader Tax Status
Achieving trader tax status is something you cannot elect when you file your taxes. Instead, you have to notify the IRS ahead of time by making a mark to market selection. This involves providing a tax return from the previous year and Form 4868—the Application for Automatic Extension of Time To File U.S. Individual Income Tax Return—along with a written declaration of your intention to make a mark to market election under section 475(f) of the Internal Revenue Code. The IRS will respond in writing with their decision. When it comes time to file your taxes, you will use Form 4797 to report your gains and losses.
How to Prove Trader Tax Status
Your tax return will speak for you. And since you are required to submit a previous year’s tax return when soliciting trader tax status from the IRS, they can use that filing to examine your income. If that includes income from buying and selling stocks, they will see it there. However, you can also include supplemental bookkeeping material. There are a number of software options out there that will keep track of your trades, record transactions and keep track of bookkeeping. But remember, the real factors considered by the IRS are discussed above. In their own words, they assess typical holding periods for securities bought and sold, frequency, volume, time invested, and the extent to which you pursue trading for livelihood. Contrary to what you might expect, there is no concrete definition of how to meet these terms to satisfaction, and the election of trader tax status occurs on a case by case basis.
Do Day Traders Have to Pay Self-Employment Tax?
Taxable earned income includes money earned from wages, tips, salaries, and bonuses—not investments. If a day trader does have another stream of income that involves self employment (such as consulting), they will have to pay self-employment tax on that stream of income. But if a trader qualifies for trader tax status, they don’t need to pay self-employment tax on the money they make from day trading.
If day trading is your only source of income, you can avoid self-employment tax entirely, but you will still have to pay capital gains tax. In most cases, you will be paying short term capital gains tax (applicable to investments held less than a year) which, incidentally, in most cases is comparable to income tax after all.
At the end of the day, a trader may want to parse out the tax consequences of stock trading and options trading to discuss the best approach. Keep in mind that day traders who are actually successful with what they do are usually involved in trading full time. Again, this isn’t just hitting the buy or sell button on a stock app. In most cases, it involves statistical research of the market, analysis of companies, and even traveling to meetings. Day trading done right is a serious business.
Trader Tax Status Offers Great Flexibility
Trader tax status allows traders to categorize their attempt to make capital gain on daily market movements as a sort of ordinary income for tax purposes, instead of the penalizing capital gain taxpayer rate. Moreover, it allows them to write off investment expenses as business expenses, further reducing their tax burden, and eliminates the wash sale rule, giving them greater flexibility in their tax planning.
As it turns out, tax trader status is not the end all be all. Since those who are trading securities have to apply based on the previous year’s tax return, it’s hard to say whether or not it will benefit you in the following year. After all, who can predict the future, especially when it comes to buying and selling stocks? Moreover, it does not offer any legal protection for your assets; the stock portfolio (albeit a very fluctuating one) is still under your own name and can be subjected to the attack of a frivolous lawsuit. A qualified accountant with experience working with day traders can discuss with you the best stock investing tips for tax and asset protection purposes.
It might be more beneficial both in terms of consistently reducing your tax burden and limiting the liability of your assets to structure your stock trading as a business. While trader tax status does give you the benefits of categorizing your business activities as a trading business for tax purposes (and offers tax benefits accordingly), it does not put you or your assets into the actual category of a separate business for the purpose of asset protection. This is why we recommend working with a professional to form a legal business entity.
We also recommend working with a tax advisor who can go over professional tax strategies for your business. If you structure your trading activities as a business, the wash rule will once again come into play, but the benefits in terms of asset protection and estate planning will far outweigh any drawbacks.
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