Do you invest in securities for your own account? If yes, do you know whether you are an investor or a trader? Is there a difference?
As a general rule, the IRS will classify most of you as investors. The IRS will treat the income from the sale of your investments as capital gains and losses. The long term capital gains (held more than one year) will be taxed at preferential capital gains rates. For those of you with net capital losses, the losses are limited to a $3,000 ($1,500 if married filing separately) per year deduction once any capital gains have been offset.
There are also many limitations on your investment expenses. Your investment expenses are deducted as itemized deductions (subject to the many limitations for high income earners). Also, your margin interest is deductible only to the extent of your net investment income. Other investment expenses are treated as miscellaneous itemized deductions, and therefore, may be limited by the 2% adjusted gross income threshold. In addition, your miscellaneous itemized deductions will not provide you with any alternative minimum tax benefit.
If the IRS classifies you as a trader, you will generally have a more advantageous tax treatment of your income and deductions. Your investment expenses are deducted on schedule C as business expenses, not as itemized deductions, and reduce gross income. Therefore, you are not subject to all the limitations imposed on the itemized deductions. Also, the expenses are deductible for alternative minimum tax purposes.
Plus, if you make certain elections, your gains and losses will be treated as ordinary income and loss. Ordinary losses are not limited. Finally, if you have a net loss for the year, trading losses may create a net operating loss (“NOL”). The NOL may be able to be carried back for a tax refund, or carried forward for a future tax benefit.
Passing the trader test
Factors used for classification as a trader:
- The trading must be “substantial.” While there’s no bright line test, the courts have tended to view more than a thousand trades a year, spread over most of the available trading days, as substantial. Also, traders ordinarily engage in trading activity as their sole or primary source of income.
- The trading must be designed to try to catch the swings in the daily market movements. In other words, you must be attempting to profit from these short-term changes rather than from the long-term holding of investments. So the average duration for holding any one position needs to be very short, generally only a day or two.
If you satisfy these conditions, the chances are good that you’d ultimately be able to prove trader vs. investor status. Of course, even if you don’t satisfy one of the tests, you might still prevail, but the odds against you are higher. If you have questions, please contact me at email@example.com.
Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.