Day Traders
There has been a lot of interest in day trading. The courts
generally use the term trader instead of day
trader. A day trader is
not necessarily a trader for tax purposes and a trader for tax
purposes is not necessarily a day trader.
Why should I care if I am a trader for tax purposes?
Investors deduct investment expenses as miscellaneous itemized deductions.
So for investment expenses to do an investor any good first they have to
itemize. Second they have to have miscellaneous deductions for investment
expenses, employee business expenses, etc. in excess of 2% of their adjusted
gross income (AGI). The miscellaneous deductions below 2% of AGI are
lost. For example, an investor with AGI of $100,000 loses $2,000 of their
miscellaneous deductions. Finally miscellaneous deductions are not allowed
for the Alternative Minimum Tax (AMT).
A trader claims his trading is a business and is not subject to the
limitations of an investor.
So who is a trader? In Humes
Houston Hart v. Comm. the tax court provides a two prong test for
determining if a person is a trader. The court said (citations omitted):
In determining whether a taxpayer who manages his own
investments is a trader, we consider the following
nonexclusive factors: (1) The taxpayer's investment intent; (2) the nature of
the income to be derived from the activity;
and (3) the frequency, extent, and regularity of the taxpayer's securities transactions. Thus, a taxpayer is engaged in
carrying on a trade or business as a securities trader only where both of following are true:
(1) The taxpayer's trading activity is substantial.
In this regard, the taxpayer's trading activity must be frequent, regular, and continuous enough to constitute a trade or
business; sporadic trading does not constitute a trade or business.
(2) The taxpayer seeks to catch the swings in the
daily market movements, and to profit from these short-term changes, rather than
to profit from the long-term holding of investments. In connection with this, courts look at
whether the taxpayer's securities income is principally derived from frequent
and substantial sale of securities rather than from dividends, interest, or
long-term appreciation.
Both factors have to be met to be classified as a trader. So how
much trading activity is substantial? No one knows for sure. There is no
bright line test. Is it 500 trades a year, 1,000, 2,000?
The second test is a little clearer, but there is still no bright line
test. Buy and hold investing doesn't qualify. However
if you start each day without any stocks, buy and sell stocks, and end the day
without holding any stock, then you should meet the second test. (This is
my definition of a true day trader).
Stephen
and Jane Marrin v. Comm. is
another recent case. You should note that in both the Marrin case and the
Hart case the taxpayers lost. In Bielfedt v. Comm.
the taxpayer wanted to be classified as a dealer but the court saw Bielfedt as a
trader instead. So while Bielfedt lost his case it is an example of a
taxpayer qualifying as a trader.
Where can I find out more? Here are a couple of links to more
information on day trading. As we are not associated with either site we
cannot be responsible for any errors or omissions. As with our site you
should consult with your own tax advisor before acting on any of the
information.
Both sites mention the mark-to-market election. You can read the code
section to learn more about the mark-to-market election. Before making the
election you should keep in mind that the election is irrevocable without the
IRS's consent and the IRS won't consent just because the election didn't work out to
your advantage. Making the election does NOT make you a trader.
Consult a professional. This is a complex area of the tax
law. Please consult a professional and make sure you understand the
consequences before you file your return as a trader and before you elect
mark-to-market.
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