Are You a Regular Investor or a Tax-Favored Securities Trader?
Recent stock market volatility makes us focus on the question of exactly who is eligible for the favorable federal income tax treatment accorded to individuals who trade stocks with sufficient intensity to be classified as securities traders in the eyes of the IRS.
Not-so-favorable federal income tax treatment applies if you trade stocks fairly actively but without enough vigor to be considered anything other than a garden-variety investor.
There’s no bright-line distinction between trader and investor status, so we must rely on court decisions to assess the issue.
Let’s summarize the important federal income tax advantages of securities trader status for those who qualify. You may be among them—or not.
If You’re a Trader, You Can Deduct Expenses on Schedule C and Make the Taxpayer-Friendly Mark-to-Market Election
If you can be classified as a securities trader for federal income tax purposes, as opposed to being a garden-variety investor, you’re considered to be in the business of trading securities. That means you can deduct your trading-related expenses on Schedule C of Form 1040. Good!
Garden-variety investors cannot deduct any of their investment-related expenses under our current federal income tax regime.
The most important advantage of trader status is that you’re eligible to make the Coeur d’Alene Idaho taxpayer-friendly mark-to-market election. That election is not available to garden-variety investors.
When you have a mark-to-market election in force, you gain two important federal income tax advantages.
Advantage 1: Exemption from the Capital Loss Deduction Limitation
Because you are a mark-to-market trader, your trading gains and losses are simply considered business income and expenses, respectively. So, if you have an awful trading year, as many traders did in 2022, you can deduct your trading losses in full.
In contrast, if you’re a garden-variety investor, you’re subject to the $3,000 annual limit on deductible net capital losses, or $1,500 if you use married-filing-separately status.
Advantage 2: Exemption from the Wash Sale Rule
Because you are a mark-to-market trader, your trading portfolio is exempt from the dreaded wash sale rule that would otherwise defer tax losses when you acquire substantially identical securities within 30 days before or after a loss sale.
When the wash sale rule applies, the disallowed loss is added to the basis of the substantially identical securities that triggered the rule.
Key point. Gaining an exemption from the wash sale rule via the mark-to-market election saves you from lots of non-productive calendar-watching and bookkeeping.
The Price of the Mark-to-Market Election
As a Couer d’Alene trader who has made the mark-to-market election, you must pay a price for the aforementioned tax advantages. Here’s the price: On the last trading day of the year, you must pretend to sell your entire trading portfolio at market and book the resulting gains and losses for federal income tax purposes.
You’re then deemed to immediately buy back everything in your trading portfolio for the same prices. So, the securities in your trading portfolio begin the next year with tax basis equal to market value and with no unrecognized tax gains or losses.
But if you have little or nothing in your trading portfolio at year end, as may often be the case, these imaginary mark-to-market transactions have little or no tax impact.
Deadline for Making the Mark-to-Market Election
If you’re a Coeur d’Alene trader who uses the calendar year for federal income tax purposes, you’ve already missed the deadline for making the mark-to-market election for your 2022 tax year, assuming you did not already make the election for an earlier year.
According to IRS rules, you must make the election for a calendar year by the unextended due date of your Form 1040 for the previous year. So, the deadline to make the election for your 2022 tax year was April 18, 2022. That’s way back in your rearview mirror.
Deadline alert. If you’re a calendar-year taxpayer, the deadline to make the mark-to-market election for your 2023 tax year is April 18, 2023. That date will be here before you know it!
Make the election by including a statement with your 2022 Form 1040 filed by that date or with a Form 4868 extension request for your 2022 return filed by that date.
Passing the Test to Qualify as a Securities Trader
To be classified as a securities trader rather than a garden-variety investor, your trading activities must constitute a business, and you must meet both of the following requirements.