If learning how to trade wasn’t confusing enough, throw day trading taxes in the mix, and you’ve got a recipe for disaster if you’re not careful. Whether you’re trading full-time from the beach or trying to shore up some extra cash for a vacation, you’ve got a huge variety of tax implications to consider.
Below are some of the basics about day trading taxes that can help you optimize your trading and best navigate your mandatory payments to Uncle Sam.
Table of Contents
Are There Day Trading Tax Benefits?
First things first, did you know that the IRS offers a number of tax benefits for day traders? Who would have thought the government would be so giving; certainly not me. Keep reading to find out what those day trading tax benefits are.
Capital Losses
It’s sad but true; many day traders lose a lot of money because they don’t properly manage their risk. And if for whatever reason – over-trading, lack of a trading plan – you lost money day trading, you can get it back—sort of.
For those of you down on your luck, I have one word: Form 1040. Schedule D of IRS income tax form 1040 allows day traders to claim $3,000 in capital losses.
How great is that? Granted, you must provide receipts, but that’s not hard since all our trade information’s electronically stored at our brokerage firm.
Also, keep in mind the wash sale rule. In short, it states you can’t hold shares of the stock you want to claim on a tax refund 30 days before or after the holding period.
Any losses over $3,000 can’t be claimed and are simply carried forward as a straight loss. But, I have something even better than the ability to claim $3,000! Yes, better.
Topic No. 429, Traders in Securities (Information for Form 1040 or 1040-SR Filers).
Trader Tax Status Designation (TTS)
For those of you who just dabble in the stock market, form 1040 might be the extent of your tax deductions. However, more serious traders, those logging more than 4 to 5 trades a day each week, might qualify for Trader Tax Status. I recommend checking out the IRS web page for qualifying information.
The benefit of this designation is the number of tax-saving opportunities it opens up. Having TTS allows professional traders to report their trading income and liabilities as Schedule C business expenses.
What’s more, you just might be eligible for the 20% qualified business income. The direct benefits to this designation include the ability to deduct items such as trading and home office expenses.
Mark-To-Market Traders
The direct benefit to a TTS designation is the ability to deduct losses beyond the $3,000 allowed as capital losses. The IRS enables mark-to-market traders to deduct an unlimited amount of losses.
Instead of schedule D, mark to market accounting uses form 475(f). To qualify, day traders must trade the same stock within a 30-day window.
What Is Mark-To-Market Accounting?
Typically, we use the cash basis method of accounting for tax purposes. In this approach, you don’t realize a gain or a loss until the year you close your position in a specific security.
However, “mark to market” or “MTM” is an accounting method in which you realize a gain or loss without closing your position. You simply “pretend” you closed your position on the last business day of the tax year, using the security’s current market price.
Now, not all securities get marked to market at year-end for income tax purposes. But, specific securities – those we consider IRC Section 1256 contracts do. You can see them listed below:
Do Day Traders Pay Quarterly Taxes?
When we think of tax season, we think of April right? With day trading taxes, we may have to pay taxes quarterly. That would mean paying a tax payment every 4 months. If your profits are larger than your losses, and that’s the goal, you may need to pay quarterly. It’s always best to check with your accountant on that.
1. Electing to Use Section 475(F) for Massive Tax Savings
In 1997, any active traders who qualified for “trader tax status”, were allowed to utilized MTM accounting. And many did as Section 475 means you’ll avoid wash sales and the capital loss limitation.
According to the IRS:
“A trader in securities or commodities may elect under section 475(f) to use the mark-to-market method to account for securities or commodities held in connection with a trading business. Under this method of accounting, any security or commodity held at the end of the tax year is treated as sold (and re-acquired) at its fair market value (FMV) on the last business day of that year.”
Going forward, the year-end prices become the cost basis of your open positions for the following tax year.
What Are the Pros and Cons of Using MTM Accounting?
PROS: A POTENTIAL REDUCTION IN TAXES/SIMPLIFIED TAXES
Without a doubt, two major advantages of electing to use MTM is the ease in filing and a potential reducing in their taxes. However, this doesn’t come without risks and warnings; certain processes must be followed to a T.
In a nutshell, we have two major advantages of electing MTM accounting when calculating your day trading taxes:
- You have no wash sales to report to the IRS since all your positions are marked to market at year-end.
- In the unfortunate circumstance, you lost more than $3,000 trading, you can deduct this loss from your income. If you’re lucky, this may possibly amend your previous year’s return, and you may get a refund.
If you are an active day or swing trader in the securities or commodities market and elect for M2M, then the following benefits can be yours.
No Capital Gains or Losses
If you’re a kick-ass trader making bank, you usually would have to claim those profits as capital gains. But, not with M2M. If you opt for this scenario, any of your wins or losses are treated as ordinary income and losses.
Let’s say you didn’t have a trading plan in place or opted for a less than stellar trading community. Sadly, but predictably, you lost your shirt to the tune of $100,000. When it comes to income tax time, you can only claim capital losses of $3,000 ($1,500 if you’re married and filing separately).
What about the $97,000 other dollars? Well, you get to carry it forward to the years to come. At $3,000 a year, you’ll need a lot of years to recoup that amount.
“By opting for MTM status, the limitations on capital losses do not apply.”
Translated into simple language: If you did lose your shirt, you’re not limited to the normal $3,000 maximum deduction. You’re able to deduct your entire loss against other types of taxable income.
Tax Loss Insurance for Day Trading Taxes
What if you found yourself in the unfortunate situation where you had two killer awesome trading years, but your profits took a nosedive the following year?
Luckily, MTM accounting provides you with a get out of jail free card good for two years prior!
You can go back up to two tax years prior and claim your losses for the current year. And you may even find yourself in a situation where you get a refund!
No Wash Sale Rule for Day Trading Taxes
When you have MTM trading status, the wash sale rule does not apply to you. Not only is this great news for day traders, it just might save you quite a bit of heartache come tax time.
Cons: You’re Forced to “Close” Using Year-End Prices
Let’s say you time your buy of Telsa before it shot up to the moon. Unfortunately, if you elected MTM status, you need to “close” your position and realize all those hefty profits.
A consequence of this is that it increases your current year taxable gain. So be aware of this and time your MTM accounting method wisely.
What Can You Write off as a Day Trader?
Write offs are great for businesses and individuals. Can you have write offs with day trading taxes? You have expenses right? The day trading computer setup you have, tools like scanners or news, trading subscriptions, trading commissions, accounts or anything you spend money on to help you trade. These are things you can potentially write off. Does that mean you can write off your Bullish Bears membership?
Key Takeaways
- The direct benefit to a TTS designation is the ability to deduct losses beyond the $3,000 allowed as capital losses.
- When using MTM, you realize a taxable gain or loss on your holdings even though your position is still open.
- Section 475 means you’ll avoid wash sales and the capital loss limitation.
- If you have TTS, timing matters for your Section 475 election. Make sure you don’t miss the date.
Day Trading Taxes Final Thoughts
I once heard a quote that said the only two things certain in life are death and taxes, and I tend to agree. No one likes to pay taxes, and if you’re a day trader, you need to do your homework. You’re not exempt from day trading taxes.
There are many nuances and misconceptions about Section 475 mark to market accounting, that is why it’s essential to learn the rules. Hire yourself a good accountant, so there are no surprises come tax time.
