eople today are much more familiar with the workings of the stock market and more likely to have investments in securities. Armed with some basic knowledge and using discount brokers (to save on transaction costs), many individuals buy and sell stocks on a regular basis.
Taxpayers who buy and sell securities are classified as dealers, traders or investors. The distinction is important because a taxpayer’s status determines the tax ramifications of his or her trading.
Dealers. In general, those individuals who have an established place of business and regularly purchase securities for resale to customers are dealers. As such, they are in the trade or business of selling and buying, and the general business income and expense rules apply.
Investors. Taxpayers who buy securities with the intention of holding them for their long-term appreciation and/or interest or dividends are considered investors.
Typically, investors’ long-term gains are taxed at a 20% rate; net long-term and short-term losses generally are limited to $3,000 per year. Investment expenses are deductible on schedule A, subject to a 2%-of-adjusted-gross-income limit; any such deductions are added back to income for alternative minimum tax (AMT) purposes. Any margin interest paid on investments is currently deductible only to the extent of investment income.
Traders. A taxpayer who trades significantly and continuously in an effort to profit from short-term changes in the price of a security may be considered a trader based on the facts and circumstances of his or her situation.
Substantial trading activity. The trading must be substantial. Merely keeping a record of, and collecting interest and dividends on, investments is insufficient, regardless of how large the total amount of investments and how continuous the work. It helps if the taxpayer devotes substantial time to studying corporations, their financial statements and the prices of their securities, and if the transactions are the main source of his or her livelihood.
Frequent trading based on daily market swings. The type of income a taxpayer receives, rather than the amount of time and effort required to obtain it, is important.
There are significant tax advantages to being classified as a trader. Expenses incurred are deductible without the 2% limit applicable to investors; in addition, these expenses are not added back for AMT purposes. Margin interest associated with the trading activity is fully deductible and not subject to any interest expense deduction limits.
Expenses incurred by a trader reduce his or her adjusted gross income for purposes of phasing out itemized deductions. A trader’s activity is not subject to self-employment tax, and he or she may elect to expense certain depreciable assets used predominantly in the trading activity.
Section 475(f) election. An additional advantage for a trader is being able to make a section 475(f) “mark-to-market” election. In such an election, the trader’s short-term capital gains or losses are converted into ordinary income or loss; losses that otherwise would have been limited to $3,000 are fully deductible against ordinary income in the current year. Also, the trader does not have to comply with the “wash sale” rules (which generally apply to prevent loss deductions on “substantially identical” securities bought within 30 days before or after a sale).
To be eligible for section 475(f) treatment, a taxpayer must make an election by the due date of the previous year’s return. Thus, because this must be done before the majority of trades have likely been completed, the taxpayer should carefully consider whether such an election makes economic sense based on his or her financial circumstances.
For a detailed discussion, see “Securities Trader Reporting Requirements,” by Thomas Rolfe Pudner, in the October 2000 issue of The Tax Adviser.
—Nicholas Fiore, editor
The Tax Adviser