The average American taxpayer is not aware that people who officially qualify as running a trading business receive special tax treatment. Their income comes from the profit they make by trading options, equities and other asset classes, and is viewed as “investment” income. Investment income is taxed differently than salary and wages, which are considered “earned” income.
There are significant differences between the way that investment income and earned income are taxed and how the two can be combined. Let’s take a closer look at what being considered a trader entails, and what its impact could be.
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TRADER TAX STATUS
The Requirements for Being Considered a “Trader”
The Internal Revenue Service defines a “trader” as a person in the business of buying and selling securities for their own account. The criteria for this classification include:
- Seeking profit from the daily movements of the market and from changes in securities prices rather than from interest, dividends or the appreciation of capital
- The level of activity of trading must be considered substantial
- The activity must be conducted regularly and continually
There are also specific criteria for qualifying as a “trading business.” They are:
- Adhering to typical holding periods for buying and selling securities
- How often you trade during the year and what the dollar amount of those trades are
- How much the business’ trading is done for the purpose of livelihood income
- How much time is spent on trading
Even if you consider yourself or call yourself a trader, a day trader, or a trading business, the IRS will analyze the levels for each and determine whether they are high enough for you to get the tax benefits that go with the title. Those whose volume does not reach the IRS’ qualifying levels will be considered an investor.
See this related post from Dennis Harabin: Understanding the Taxation of Cryptocurrency Transactions
One of the big issues of cryptocurrency is how it is treated for tax purposes. The IRS says that it is property, so that every time it is traded, sold, or used as money in a transaction, it is treated much the same way as a stock transaction would be, meaning the gain or loss over the amount of its original purchase cost must be determined and reported on the owner’s income tax return. That treatment applies for each transaction every time cryptocurrency is sold or used as money in a transaction, resulting in a major bookkeeping task for those that use cryptocurrency frequently.
What are the advantages of qualifying as a trader?
Consider a scenario in which an individual earns a wage of $100,000 and an additional $30,000 by trading stocks. As an investor, the $30,000 will be taxed at either the short-term or long-term capital gains rate depending upon how long you held the position. Likewise, if you lost that same amount from your investments, you would be unable to reduce your earned income by that amount: you would be limited to no more than $3,000 in losses against earned income and still be taxed on $97,000 of taxable income. As a qualified trader, however, you are entitled to approach the taxes on gains and losses differently, using an accounting method called “mark-to-market” that determines values using prevailing market price. The $30,000 in losses on your trades would be subtracted from your $100,000 in wages, reducing your taxable income to $70,000.
It seems pretty obvious, therefore, that anybody who can qualify as a trader should do so, but it is not that simple. You can’t look at your successes or failures as a trader and then decide at tax filing time what you want to do: It is a status that you need to elect in the previous year.
Determining that you qualify for this status can lead to filing other advantages. For example, filing Form 6781, Gains and Losses from Section 1256 Contracts and Straddles, is specifically for those whose trades include products like foreign exchanges, index options, traded futures and other marked-to-market products. These provide you with a special 60/40 tax treatment under which as long as you’ve been holding your position for a specific period of time — even as short as three days — you’ll be able to have them taxed as though 60% are long-term capital gains and 40% are short-term capital gains. A $1,000 net gain on an index option would only see 40%, or $400, taxed at the higher short-term capital gain rate that is the same or ordinary income, while $600 (or 60%) would be taxed at the lower long-term capital gains rate.
Similarly, traders’ contracts qualify for Section 1256 treatment, avoiding wash sales rules that apply to investors. For an investor, securities that are sold at a loss and then bought again within a 61-day window measured as being 30 days before or after the closing transaction cannot be recorded as a loss. Instead, it is measured based on the cost basis of the shares that you repurchase, and the loss can’t be taken until those newer shares are finally liquidated, at some point in the future. Everything gets adjusted, thus disallowing the original loss, and this is true even if you are using two different brokerage accounts. You can’t avoid the wash sales rules by selling for a loss in one account and buying back using another. As a qualified trader, however, wash sale rules don’t apply. Gains are carried over to Schedule D, while losses can be used to offset gains for previous years or for the current year.
See this related post from Dennis Harabin: Understanding The Qualified Small Business (QSB) Stock Gain Exclusion
Originally, selling stocks identified as having Qualified Small Business status was viewed as offering marginal benefit. But the last several years have seen incremental changes to how gains from the sales of these stocks have been treated. As of the most recent shift, which created a 100% exclusion with certain limitations, these stocks now offer significant opportunities for those who invest in startups and other small businesses.
Those who trade options are able to take advantage of several different protective tax strategies. These include:
Offsetting Gains by Purchasing Put Options
The short-term tax consequences that come from having substantial gains on large stock positions can be offset by buying stock puts. But you need to remember that if the stock price continues to rise, you run the risk of losing your money when the put expires. By choosing an OTM – or out of the money – Put, you could lose the entire premium as well as the cost of the transaction. The longer the option, the greater the “theta” meter of loss. A better, safer option might be to choose in-the-money options, which retain some of their intrinsic value – though they can still end up expiring with no value.
To help with theta risk, consider buying in-the-money options, because they’ll have some intrinsic value and not all “time” value, initially. Of course, they can still expire worthless if they’re OTM at expiration, but the risks are lower.
Another possibility is to get a tax advantage by trading option contracts that expire far in the future. Known as LEAPS, or Long-term Equity AnticiPation Securities, these have expiration dates as far in the future as 32 months. The length of time that you hold them will determine their tax treatment, but there are clear advantages compared to what is offered by buying and selling the more traditional short-term alternatives. The fact that LEAPS can be held for more than a year means that profits can be treated and taxed as a long-term gain and offer a great way to diversify your portfolio.
You can trade an Individual Retirement Account (IRA) or any self-directed retirement account and realize significant tax benefits in some cases. The key is to do your research into what your brokerage allows, as some allow options in IRAS and others do not. If you can use this strategy, you will find that the wash sale rules essentially don’t apply because you will only be taxed when a distribution is made. If the account is taxable, however, it may trigger a wash sale.
If you’re a small business owner or an aspiring entrepreneur, mergers and acquisitions probably sound like something that happens at an entirely different operational level from the one where you live and work. But if you’ve put the time into creating a business plan and invested hours in the health and welfare of your business, then it’s more than worth your while to learn the basics – it may even be the difference between your business’ success and its failure.
Hedging through Index Options
You can realize preferential tax treatment through options on the Nasdaq-100 (NDX), the S&P 500 Index (SPX), and other broad indices — as well as futures contracts — if you do so using Section 1256 contracts.
Traders and investors alike can realize significant savings by consulting with a tax professional who can help them navigate the complexities of short- and long-term gains. For assistance from an experienced tax advisor, please give us a call at 551-249-1040.
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