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Tax Advantages of Day Trading

This section is intended as a general discussion and should not be interpreted as tax or legal advice. Seek the professional advice of a CPA or tax attorney as to the applicability of the rules to your specific situation.

The tax laws allow considerable benefits to those that are eligible for trader status. First of all, the investment expenses are not subject to the 2% floor on itemized deductions.  Secondly, the investment interest limitations do not apply.  And, most importantly, any gains or  losses are excluded from calculating self-employment income and consequently, not subject to self-employment or social security tax!.  Is this cool or what?

The definitions used in determining whether or not someone is a trader are not rigidly codified and consequently, small factual differences may change an individual's status. There are three types of classifications 1) dealer, 2) investor, and 3) trader.

     1)  A dealer treats the gains and losses from stock or securities transactions as ordinary income; equity and non-equity options are treated as capital subject to market rules and the 60% long-term gain/loss and 40% short-term gain/loss.  A dealer's expenses are business expenses not subject to the 2% floor on miscellaneous itemized deductions.

     2)  An investor reports the gains and losses from their stock or securities, equity options, non-equity options and futures contracts as capital gains and losses. The non-equity options and futures contracts are marked at the market at year end and are treated as 60% long-term gain/loss and 40% short-term gain/loss. Any expenses are treated as income producing expenses and are miscellaneous itemized deductions subject to the 2% rule.

A trader treats the gains and losses the same as an investor, but the expenses are now business expenses and are not subject to the 2% floor on miscellaneous itemized deductions.

It appears that the primary differences between an investor and a trader is the frequency with which trades occur, the personal management of one's account, and the holding period of the security. If the motive is to seek profit through capital appreciation, dividends, and interest then the classification will probably be investor. 

The principle distinction appears to be that capital appreciation is deemed to be a longer term perspective, even though the transaction may close within one tax year and be deemed a short-term capital gain.

      3) Traders have some if not all of the following characteristics:

  • Buy and sell frequently to catch short-term, daily market moves.
  • Profits are derived from direct management by the trader of his/her own account.   
  • Income is primarily derived from the purchase and sale of securities and not dividends and  interest.
  • The intent of the taxpayer; the type of  income; and the frequency, extent, regularity and time spent are all pertinent factors.
  • Trading is not treated as a secondary profession (the income must be substantial and the trader must also be available during market hours to make trades).

Try this excellent resource, the U.S. Tax Code On-line with a full-text search engine.

Hopefully, this has been of some preliminary help for those readers that have interest in the tax aspects of daytrading.  Again, these very general comments and observations should not be interpreted as tax or legal advice. Therefore, seek the professional advice of a CPA or tax attorney as to the applicability of the rules to your specific situation.

 
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