Paying the Piper: Some Tax Rules for Daytraders

TAX BRIEF

INDIVIDUAL

One of the new vocations of the Internet age is day trading; it is characterized by traders’ rapidly buying and selling securities to take advantage of small movements in their value and liquidating the portfolios by the end of the trading day. Coverage in the news media has generally focused on the lack of regulations governing the industry, the large losses that have prompted some day traders to act irrationally and the few successful traders who have earned large profits. But the news media has barely discussed the tax rules covering these trading transactions.

The Taxpayer Relief Act of 1997 contained several provisions that both help and hurt day traders in their computation of income taxes. First, the act permits the day trader to use mark to market accounting for his or her security portfolio. This allows him or her to recognize gains or losses in the value of a security portfolio before a gain is realized by the sale of a security. Since day trading is characterized by rapid turnover of securities and the day trader does not want to hold securities overnight, the effects of this provision are hard to determine.

Second, a day trader can classify his or her activities as a business to be reported under schedule C of form 1040. This is significantly better for the trader than the provisions that applied before the act went into effect. Previously, a day trader was limited to annual capital losses of $3,000, regardless of whether he or she had short- or long-term losses. But if he or she files as a business, there is no limitation to the total losses that can be taken. Since many day traders have experienced large losses, this is a significant tax benefit.

Third, the trader has greater latitude in deducting costs. As an individual, the day trader would have to deduct business costs on schedule A of form 1040 where 2% of adjusted gross income is first subtracted from the deduction. But if that trader classifies his or her activities as a business, such expenses—which include computer equipment, software, communication expenses, margin interest and related items—are fully deductible, and the 2% rule does not apply.

However, there are several negative tax rules associated with day trading. First, any gains are subject to both income and self-employment taxes. The trader would have to pay employment taxes as a self-employed individual for the net business gains over the tax period.

In addition, the act placed certain accounting burdens on the day trader. He or she must segregate investments into trading securities and investment securities. This means that the gains and losses from the investment securities are recorded on schedule D and the trading gains and losses are recorded on schedule C. There is no specific regulation to use as a guide in differentiating the securities into trading and investment portfolios.

Finally, the IRS has issued no formal guidelines as to who qualifies as a day trader. Some factors that might be relevant would include (1) the number of trades an individual makes, (2) the intent of the individual, (3) how long an individual holds securities and the amount of time devoted to trading activities, (4) sources of income other than day trading and (5) the nature of the investment account and the relationship the individual maintains with the investment bank.

—Marc I. Lebow, CPA, PhD, associate professor of
accounting at Christopher Newport University in
Newport News, Virginia, and
P. Michael McLain, CPA, DBA, assistant professor of
accounting at Hampton University, Hampton, Virginia.