The proliferation of retail trading has brought challenges as well as new opportunities for accountants. Because the tax rules surrounding day trading can be murky and complex, clients who day-trade as either a primary or secondary source of income may require the services of a tax professional. One important area in which this steadily growing group of clients may need advice is whether to make a Sec. 475 mark-to-market election.
In this article, we offer some thoughts on day trading from a tax planning perspective. Practical examples are provided to illustrate the tax difference between making the Sec. 475 election versus not making the election.
THE POPULARITY OF DAY TRADING
Day trading typically refers to active trading by retail or proprietary traders who take short-term positions in any of a broad class of financial assets, including traditional stocks, bonds, currencies (including virtual currency), commodities, futures, and, increasingly, options on these assets. Positions are typically held for as little as a few seconds (known as scalp trading) up to several days (known as swing trading). The day trader's intent, of course, is to buy an asset for a low price and sell it at a higher price within a short time frame (in the case of a long position; a short position does the same in the opposite order).
An increasing number of online brokers provide software and platforms for day traders, who can use margin loans from the brokerage to increase their buying power to sometimes three to four times their own equity capital. With the recent advent of Robinhood, one of the first online trading platforms to allow its retail clients to place trades with $0 commissions, day trading became accessible globally to the general population. The popularity of this pursuit has driven several traditional banks and brokerages to follow suit and offer commission-free trading to their retail clients in addition to a more expensive alternative that charges commissions for enhanced services. In making commission-free trading available, these financial institutions see an opportunity to profit from extending margin loans to their trading clients.
In principle, day trading is like any other business in which inventory is purchased at a lower price and sold at a higher price (i.e., buy low, sell high). One difference, though, is that in the financial space, both a purchase and sale can be executed instantaneously, generating quick profits or losses. With the increased accessibility of day trading, training courses to educate anyone interested in how to trade financial assets have proliferated on the internet.
Just like with any business, trading in financial assets requires investment in equipment (e.g., hardware and software) and the payment of regular expenses including commissions, platform fees, data fees, interest on margin-based loans, and office expenses. Profit or loss from day trading has tax implications for the trader's other income-generating activities.
TRADER IN SECURITIES
Typically, a day trader, because of the nature and extent of the trading activities, will for federal tax purposes qualify as a trader in securities (i.e., an individual who is in the business of buying and selling securities for his or her own account). If a day trader is considered a trader in securities, he or she can make the Sec. 475(f) mark-to-market election (discussed below).
However, an individual will not be considered a trader in securities simply because the individual calls himself or herself a trader or day trader or engages in a limited amount of trading activity, regardless of its nature. To be considered a trader in securities, rather than an investor, an individual must:
- Seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
- Engage in substantial activity; and
- Carry on the activity with continuity and regularity (see IRS Publication 550, Investment Income and Expenses, p. 68 (rev. March 10, 2022)).
If these requirements are not met, the individual will be considered an investor, not a trader in securities whose trading activity is treated as a business. The determination of whether an individual is a trader in securities is based on the facts and circumstances of his or her trading activity. Factors relevant in determining whether someone qualifies as a trader are discussed in IRS Topic No. 429 and summarized in the table "Distinguishing Traders From Investors" below.
If a day trader who qualifies as a trader in securities has not made the Sec. 475(f) election, the day trader's sales of securities result in capital gains and losses. Sales that yield long-term capital gains are taxed at the preferential capital gains rates, but the Sec. 1211(b) limitations on capital losses and the Sec. 1091 wash-sale rules also apply to the day trader. He or she reports sales of securities on Schedule D, Capital Gains and Losses, and on Form 8949, Sales and Other Dispositions of Capital Assets, as appropriate. Although a day trader who qualifies as a trader in securities is considered as being in the business of buying and selling securities, the trader is not subject to self-employment tax on gains and losses on his or her sales of securities.
A day trader who qualifies as a trader in securities is also allowed to deduct the expenses from his or her trading activity as business expenses because the trading activity is considered to be a business. Deductible expenses could include equipment costs such as a computer or monitors, software for trading, education classes about trading strategies, and possibly even a home office deduction. These expenses are reported on Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship). Commissions and other costs of acquiring or disposing of securities aren't deductible but must be used to figure gain or loss upon disposition of the securities.
If a day trader who qualifies as a trader in securities makes the Sec. 475(f) mark-to-market election, the day trader treats all the gains or losses from his or her trading activity as ordinary gains or losses that must be reported on Part II of Form 4797, Sales of Business Property. Neither the limitation on capital losses nor the wash-sale rules apply to the trader after making the election to use the mark-to-market method of accounting. In addition, securities the day trader holds at the close of the year are marked to market by treating the securities as being sold for fair market value (FMV) on the last business day of the tax year, with the gain or loss recognized on the deemed sales taken into account for that tax year. Despite the change in characterization of income, a day trader who qualifies as a trader in securities is still not subject to self-employment tax on the sales of securities after making the Sec. 475(f) election.
Making the Sec. 475(f) election does not change the day trader's treatment of his or her expenses from the trading activity. The expenses are treated as deductible business expenses that are reported on Schedule C.
MAKING THE ELECTION
The Sec. 475(f) mark-to-market election must be made on the tax return for the year prior to when the taxpayer wants it to take effect. For example, for the mark-to-market election to be effective for 2024, a day trader who qualifies as a trader in securities must make the election by the original due date of the 2023 tax return (not including extensions). The election is made by attaching a statement to the income tax return (or to a request for an extension of time to file that return) that includes the following information:
- That an election is being made under Sec. 475(f);
- The tax year when the election will become effective;
- The trade or business for which the election is being made (see Rev. Proc. 2018-31; see also IRS Topic No. 429).
A day trader who makes the election will also be required to change his or her method of accounting for securities under Rev. Proc. 2019-43 by filing a Form 3115, Application for Change in Accounting Method.
Benefit of making the Sec. 475(f) election
The primary benefit to a day trader of making the Sec. 475(f) mark-to-market election is that all losses from the trading activity (whether the losses are from actual trades made during the year or from marking to market all securities held at the close of the year) are treated as ordinary losses rather than capital losses. Thus, the $3,000 capital loss limitation does not apply to the losses from the trading activity if the election is made, and the trader can use the full amount of the net losses from his or her trading activity to offset ordinary income from other sources. Losses that cannot be used in the current year are carried forward as net operating losses.
While gains from the trading activity will likewise be treated as ordinary income, for day traders this will generally not result in a higher tax rate being paid on the gains because, due to the nature of day trading, most or all of the gains from the trading activity will be short-term capital gains. Furthermore, if a day trader purchases a security that he or she anticipates will be held long term, the security can be removed from the mark-to-market regime and treated as held for investment if the day trader clearly identifies in his or her records (before the close of the day the security is acquired) that the security is not connected to his or her day trading activity.
Because day traders making the Sec. 475 election must mark securities held at the close of the year to market, causing the recognition of the otherwise unrealized gain or loss in the securities, the income subject to tax and the tax liability of a day trader may be lower (if there is a net unrealized loss in the securities) for a year if the election is made. However, if there is an unrealized gain on the securities, the election will generally result in more income subject to tax and a higher tax liability.
The table "Quantifying the Effects of the Election" (below) shows the tax results for a day trader without and with a Sec. 475(f) election in three scenarios:
Scenario 1: A day trader, who qualifies as a trader in securities, has net realized losses from sales of securities during 2021 of $25,000, has $10,000 of trading expenses, and holds no securities at the close of the year. The trader also receives $95,000 of ordinary income from other sources and takes the standard deduction.
Scenario 2: A day trader, who qualifies as a trader in securities, has net realized short-term gains from sales of securities during 2021 of $30,000, has $10,000 of trading expenses, and holds no securities at the close of the year. The trader also receives $95,000 of ordinary income from other sources and takes the standard deduction.
Scenario 3: A day trader, who qualifies as a trader in securities, has net realized short-term gains from sales of securities during 2021 of $10,000, has $10,000 of trading expenses, and holds securities at the close of the year on which a net gain of $20,000 would be realized if they were sold for FMV. The trader also receives $95,000 of ordinary income from other sources and takes the standard deduction. Notice that by making the Sec. 475(f) mark-to-market election, both the realized and unrealized gain become part of ordinary income.
ADVISING DAY TRADER CLIENTS
When advising a client who day-trades or anticipates doing so in the future, a practitioner should be sure to discuss both how the client can qualify as a trader in securities and the differences between the tax treatment of trading activities with and without a Sec. 475(f) election. The election is a two-edged sword, and depending on the client's circumstances during a year, may increase or decrease his or her tax liability. Moreover, the election must be made in the year prior to being effective and once made can only be revoked with the IRS's consent. Therefore, to determine if making a Sec. 475(f) election will be beneficial, the client must realistically consider what his or her tax circumstances are likely to be in both the year the election becomes effective and future years.
About the authors
Joseph Hargadon, CPA, CGMA, Ph.D., is a professor of accounting; Irfan Safdar, Ph.D., is an associate professor of accounting; Stephanie Wendling, CPA, MS Taxation & Financial Planning, is a senior lecturer; and Eunbin Whang, Ph.D., is an assistant professor of accounting, all at Widener University in Chester, Pa. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.
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