Traders eligible for “trader tax status” (TTS) deduct business expenses, startup costs, and home office deductions. A TTS trader may elect Section 475 for exemption from wash sale loss adjustments (deferrals), the $3,000 capital loss limitation, and to be eligible for a 20% qualified business income (QBI) deduction. Trading income is not self-employment income, so TTS traders don’t owe SE taxes. Using an S-Corp, TTS traders create earned income to maximize health insurance and or retirement plan deductions.
Lacking TTS, investors get peanuts in the tax code. TCJA, the new tax code suspended investment fees and expenses along with all other miscellaneous itemized deductions subject to the 2% floor. Two itemized-deductions for investors survived tax reform: Investment-interest expense limited to investment income, and stock-borrow fees. With the state and local tax (SALT) limitation and roughly-doubled standard deduction, many investors don’t get any tax deductions for investment-related expenses.
The IRS does not permit investors to elect Section 475, so they are stuck with wash sale loss adjustments, and the $3,000 capital loss limitation. Short-term capital gains are subject to ordinary tax brackets. Investors benefit from long-term capital gains, providing the investor holds a position open for 12-months or more. Long-term capital gains rates are 0%, 15% and 20% for 2019 and 2020. Traders can have segregated investments for LTCG, too.
How to qualify for trader tax status
Satisfy the below requirements based on my analysis of tax court cases and years of experience working with traders.
· Substantial volume – at least four total trades per day, 15 per week, 60 per month, and 720 per year annualized (Poppe court). Count open and closing trades separately.
· Frequency – a trade execution on 75% of available trading days. That’s close to four days per week.
· Average holding period under 31 days (Endicott court bright-line test).
The above factors are the “big three.”
· Continuous trading with few sporadic lapses.
· Time – four hours per day, including trading, research, and administration.
· Intention to run a business and to make a living. It doesn’t have to be a primary living.
· Business setup (multiple trading devices, monitors, and a home office).
· Materiality (Pattern Day Trader minimum for securities of $25,000; $15,000 otherwise).
Assess your facts and circumstances for TTS towards the year-end. If you rise to the level of TTS, then deduct business expenses, startup costs, and home office expenses on Schedule C, a partnership, or S-Corp tax return. TTS business expenses do not require an election with the IRS; whereas, Section 475 does require a timely election. TTS does not convert capital losses into ordinary losses; a Section 475 election is necessary for ordinary gain or loss treatment.
TTS business expenses
If you are eligible for TTS, you are entitled to deduct the below items, and more:
· Tangible personal property up to $2,500 per item, including computers, monitors, desks, and mobile devices.
· Section 179 (100%) depreciation, 100% bonus depreciation, and or regular depreciation.
· Amortization (expensing) of startup costs (Section 195), organization costs (Section 248), and software.
· Education expenses after the commencement of TTS.
· Section 195 startup costs may include education expenses within six months of beginning TTS.
· Publications, subscriptions, market data, charting services, self-created automated trading systems, cloud computing, professional services (accountants and attorneys), chat rooms, mentors, coaches, supplies, media, communications, travel, meals, seminars, conferences, supplies, assistants, office rent, and consultants.
· Home-office expenses for the business portion of your home. (See Home Office Tax Deductions Are Fantastic: Learn How To Do It.)
· Margin interest expenses. (Not limited to investment income like investment interest is.)
· Stock-borrow fees and other costs for short-sellers.
Wash sale loss adjustments
Wash sale loss adjustments on securities cause headaches and potentially higher tax bills. If a taxpayer repurchases substantially identical securities within 30 days before or after realizing a tax loss on securities, the IRS uses the wash sale (WS) loss rule. That defers a tax loss to the replacement position’s cost basis.
For example, if you sell Apple stock at a tax loss on December 15, 2019, and repurchase a substantially identical position (Apple stock or option) on January 10, 2020, the 2019 wash sale loss defers to 2020. It’s critical to avoid WS at year-end in taxable accounts by breaking the 30-day chain. Sell the position by year-end for a tax loss, and don’t repurchase a substantially identical position for 31 days. If you want to catch a rally in January, then consider it may not be so bad to defer a loss as it’s just a timing issue.
It’s essential to prevent WS losses throughout the year between taxable and IRA accounts because it’s a permanent WS loss. The IRS does not allow a WS loss to be added to cost basis in the IRA.
There are other ways to avoid WS. TTS traders can elect Section 475 on securities to be exempt from WS. Traders can choose to trade instruments that are not considered securities, including futures, forex, precious metals, and cryptocurrencies.
WS rules for taxpayers and brokers are different. The IRS requires taxpayers to calculate WS losses based on substantially identical securities positions (i.e., Apple equity vs. Apple options), across all taxpayer’s brokerage accounts, including IRAs and spousal accounts if married/filing joint. Conversely, the IRS requires brokers to calculate WS based on identical securities (an exact symbol) per the one brokerage account. This apples vs. oranges is problematic since the IRS seeks to match broker 1099-Bs with taxpayer Form 8949s. Many accountants and taxpayers do not know these differences in the rules. Consider trade accounting software that is compliant with IRS rules for taxpayers, and you should explain overall differences in tax return footnotes. (See How To Avoid Taxes On Wash Sale Losses.)
Elect Section 475 for additional tax benefits
The IRS permits TTS traders to elect Section 475 ordinary gain or loss treatment on securities and or commodities. Section 475 trades are exempt from wash sale loss rules, and the $3,000 capital loss limitation. Short-term capital gains use the same ordinary rate as Section 475, except 475 also unlocks a potential QBI deduction. There are significant tax benefits on Section 475 ordinary losses vs. capital losses. TTS traders can deduct a 475 ordinary business loss against wages and other income; thereby bypassing the capital loss limitation. Excess ordinary losses are a net operating loss (NOL) carry forward.
TCJA introduced a 20% qualified business income (QBI) deduction for sole proprietors, partnerships, and S-Corps. TTS trading is a “specified service trade or business” (SSTB) subject to a taxable income threshold, phase-in and phase-out range, and taxable income cap. If you exceed the taxable income cap, you don’t get a QBI deduction on an SSTB. QBI includes Section 475 income/loss net of trading business expenses; whereas, QBI excludes capital gains/losses, interest, dividends, and other investment income. (See A Rationale For Using QBI Tax Treatment For Traders.)
Most futures traders prefer to skip a 475 election to retain Section 1256 60/40 capital gains rates; they don’t want ordinary income. However, if you have a significant trading loss in 1256 contracts, then consider a 475 election on commodities. You can revoke a Section 475 election in a subsequent year, in the same manner, you elected it. (See more about Section 475 and how to choose it in my blog post, Traders Elect Section 475 For Massive Tax Savings.)
Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update
For more in-depth information, see Green’s 2019 Trader Tax Guide.