Do You Consider Yourself a Stock Trader?

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Do You Consider Yourself A Stock Trader? Be Careful

Written by: Cynthia Yang

By default, most taxpayers who trade stocks are classified for tax purposes as “investors.” This classification confers certain tax benefits. However, individuals considered “traders” generally enjoy greater tax advantages. But even if you trade frequently and consider your trading more than a hobby, be careful about labeling yourself a trader. Misclassifying such activities could result in IRS penalties, in addition to tax plus interest.

Class benefits

If you trade stocks as an investor, any net long-term gains you realize will be treated as capital gains (15% or 20% tax rate in most cases) vs. ordinary income. That’s good news if your net gains are long term from positions held more than a year. But any investment-related expenses (such as legal and accounting) are no longer deductible. Margin interest may be deductible in some circumstances. Consult with a tax advisor before claiming such deductions. In general, traders may qualify for additional tax advantages. Their expenses may reduce gross income even if they can’t itemize deductions –– not only for regular tax purposes, but also for alternative minimum tax purposes. Plus, in certain circumstances, if they have a net loss for the year, they can claim it as an ordinary loss (so it can offset other ordinary income) rather than a capital loss, which is limited to a $3,000 ($1,500 if married filing separately) per year deduction after any capital gains have been offset.

Case law answers

It should come as no surprise that multiple taxpayers have sought to convince courts that they should be classified as traders. But these litigants usually fail and can get hit with negligence penalties on top of back taxes (not to mention legal costs). However, such cases have provided insight into what it takes to successfully meet the test for trader status. According to courts, a taxpayer’s trading must be substantial, regular and continuous to be considered a trader. Trading must be designed to capture the swings in daily market movements. And the individual must try to profit from these very short-term changes rather than from longer-term holding of investments.

What exactly counts as substantial? There’s no bright line test, but historically, certain court decisions have tended to view more than a thousand trades a year, spread over most of the available trading days in the year, as substantial. Consequently, a few hundred trades, especially when occurring only sporadically during the year, generally aren’t likely to pass muster. In addition, the average duration for holding any one position needs to be very short, preferably only a day or two.

If you satisfy all of these conditions, you may ultimately be able to prove that you’re a trader (but there are no guarantees). Of course, even if you don’t satisfy one of the tests, you might still convince the IRS or prevail in court, but the odds against you are likely higher.

Possible penalties

If the IRS disagrees with your trader status and determines that you are, in fact, an investor, you may end up liable for back taxes, interest and accuracy-related penalties. So be sure to work with a tax advisor knowledgeable about such classifications when preparing your tax return.

Important Disclosures

Investment advisory services offered through Planned Financial Services, LLC, dba Return on Life Wealth Partners, an SEC-registered investment adviser. Registration does not imply a certain level of skill or training.

The views expressed are current as of the date of publication and are subject to change without notice. This material is provided for informational and educational purposes only and is not intended as specific investment, tax, legal, or financial planning advice. Individuals should consult with qualified professionals regarding their specific circumstances.

All investing involves risk, including the possible loss of principal.

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