Day Trading Taxes

Day Trading Taxes Explained

9 min read

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 trading full-time from the beach or trying to shore up some extra cash for a vacation, you have many tax implications to consider.

Below are some basics about day trading taxes that can help optimize your trading and best navigate your mandatory payments to Uncle Sam.

First, did you know that the IRS offers many 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.

It’s sad but true; traders often lose money because they don’t properly manage their risk. And if you lost money day trading for whatever reason – over-trading, lack of a trading plan – you can get it back—sort of. 

I have one word for you down on your luck: 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 is 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 carried forward as straight losses. But I have something even better than the ability to claim $3,000! Yes, better. 

Trader Tax Status Designation

For those who 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.

Moreover, you might be eligible for the 20% qualified business income. The direct benefits of this designation include the ability to deduct items such as trading and home office expenses.

Direct benefits of 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.

Topic No. 429, Traders in Securities (Information for Form 1040 or 1040-SR Filers).

Mark-To-Market Accounting

Typically, we use the cash-based 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 “pretend” you closed your position on the last business day of the tax year, using the security’s current market price.  

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:

  • Regulated futures contracts
  • Non-equity options like bonds, commodities, and currencies
  • Exchange-traded index options (ETF/ETN options)

MTM Accounting Pros

Pros: A Potential Reduction in Taxes/Simplified Taxes

There are two major advantages of electing to use MTM: ease of filing and a potential reduction in taxes. However, this doesn’t come without risks and warnings; certain processes must be followed. 

In a nutshell, we have two major advantages of electing MTM accounting when calculating your day trading taxes:

  1. You have no wash sales to report to the IRS since all your positions are marked to market at year-end. 
  2. In the unfortunate circumstance that you lose more than $3,000 trading, you can deduct this loss from your income. If you’re lucky, this may 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.

Quarterly Day Trading 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 four 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, active traders who qualified for “trader tax status” were allowed to utilize MTM accounting. As Section 475 means you’ll avoid wash sales and the capital loss limitation, many did.

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.”

In the future, the year-end prices become the cost basis of your open positions for the following tax year.

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No Capital Gains or Losses

If you’re a kick-ass trader making bank, you usually have to claim those profits as capital gains. But not with M2M. If you opt for this scenario, your wins or losses are treated as ordinary income and losses.

Let’s say you didn’t have a trading plan or opted for a less-than-stellar trading community. Sadly, but predictably, you lost your shirt to $100,000. Regarding 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 can deduct your entire loss against other types of taxable income. 

Day Trading Taxes Insurance

What if you found yourself in an 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!

When you have MTM trading status, the wash sale rule does not apply to you. Not only is this great news for day traders, but it might save you a lot of heartache come tax time.

Forced to “Close” Year End

Let’s say you time your buy of Telsa before it shot up to the moon. Unfortunately, if you elected MTM status, you must “close” your position and realize all those profits. 

A consequence of this is that it increases your current year’s taxable gain. So be aware of this and time your MTM accounting method wisely. 

Write-Off's as a Day Trader

Write-offs are great for businesses and individuals. Can you have write-offs with day trading taxes? You have expenses. You have the day trading computer setup, 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 of 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.

Final Thoughts: Day Trading Taxes

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; you must do your homework if you’re a day trader. You’re not exempt from day trading taxes.

There are many nuances and misconceptions about Section 475 mark-to-market accounting, so learning the rules is essential. Hire a good accountant so there are no surprises come tax time. 

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