If you are an individual who buys and sells securities you may qualify as a “trader in securities,” for tax purposes. This post attempts to explain how traders must report the income and expenses from being in the trading business.
First though it is important to understand the meaning of the terms: “security,”“investor,”“dealer,”and“trader,” and the different manner in which income and expenses are reported.
Internal Revenue Code Section 1236 defines “security” basically for all intents and purposes as any share of stock in any corporation, certificate of stock or interest in any corporation, note, bond, debenture, or evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the above.
“Investors” typically buy and sell securities and expect income from dividends, interest, or capital appreciation. If you are an investor you tend to buy securities and hold them for personal investment; generally speaking you are not conducting a trade or business. Most investors are individuals. Sales of these securities result in capital gains and losses that must be reported on Form 1040, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. Investors are subject to the capital loss limitations described in IRC 1211(b), in addition to the IRC 1091 wash sales rules.
Investors can generally deduct the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible on Form 1040, Schedule A (PDF), Itemized Deductions, as miscellaneous deductions to the extent that they exceed 2% of adjusted gross income. Interest paid on money to buy or carry investment property that produces taxable income is also deductible on Schedule A, but under section 163(d) the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. On the bright side as an 'investor' your earnings are not subject to Self Employment tax.
For more information on taxes as an 'investor' check out:
IRS Topic 703, Basis of Assets
IRS Publication 550, Investment Income and Expenses.
“Dealers” in securities purchase, hold securities, and sell securities to their customers in the ordinary course of their trade or business; sometimes they maintain an inventory. Dealers may be individuals or business and are usually distinguished from investors and traders because they have customers and subsequently derive their income from marketing securities for sale, and charging their clients fees for services rendered.
If you are a dealer you are in the trade or business of buying and selling which basically means that gains and losses are classified per IRC 1236 as ordinary gains and losses.
Section 1236 requires however that as a dealer you must keep and maintain records that clearly identify securities held for personal gain versus those held for use in business activity associated with being a dealer.
Dealers who are individuals must report their expenses on Form 1040, Schedule C (PDF). They report the income in excess of their trading activities on Schedule C as well; however, they report gains and losses associated with dispositions by using mark-to-market rules addressed further down.
Special rules apply if you are a "trader" in securities. If you are in the business of buying and selling securities for your own account you can be considered in a trading business even if you do not maintain an inventory and do not have clients. To be engaged in business as a trader in securities, you must meet all of the following conditions according to IRS Publication 550:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
- Your activity must be substantial, and
- You must carry on the activity with continuity and regularity.
IRS Publication goes on to state that the following facts and circumstances should be considered in determining if your activity is a securities trading business:
- Typical holding periods for securities bought and sold.
- The frequency and dollar amount of your trades during the year.
- The extent to which you pursue the activity to produce income for a livelihood, and
- The amount of time you devote to the activity.
If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader,” you are an investor.
As with dealers, a taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to the securities held for investment. As a trader you must keep detailed records distinguishing securities held for investment from the securities held for the purpose of being in the trading business.
The securities held for investment must be identified as such in the trader's records on the day he or she acquires them ideally by holding them in a separate brokerage account.
Traders report their business expenses on Form 1040, Schedule C (PDF), Profit or Loss From Business. The Schedule A limitations on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business. Commissions however and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. See Topic 703, Basis of Assets.
Dividends, interest from securities, and gain or loss from the sale of capital assets are not considered proceeds from self-employment income unless received by a dealer in stocks and securities in the course of their business according to IRS Form 1040, Schedule SE Instructions, Self-Employment Tax.
In addition to the deduction of business expenses on Schedule C, traders are entitled to use the mark-to-market election. The tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under IRC 475(f) to use the mark-to-market method of accounting. If the mark-to-market election was not made, then the gains and losses from sales of securities are treated as capital gains and losses that must be reported on Form 1040, Schedule D (PDF).
When reporting on Schedule D, both the limitations on capital losses and the wash sales rules continue to apply. However, if the mark-to-market election was timely made, then the gains and losses from sales of securities are treated as ordinary gains and losses (except for securities held for investment) that must be reported on Part II of Form 4797 (PDF), Sales of Business Property.
Neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.
In general, the mark-to-market election must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. The election is made by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:
- That you are making an election under section 475(f) of the Internal Revenue Code;
- The first tax year for which the election is effective; and
- The trade or business for which you are making the election.
Refer to the Form 1040, Schedule D Instructions, Capital Gains and Losses, for further instructions on how to make the mark to market election.
After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2011-14. In addition to making the election, you will also be required to file a Form 3115 (PDF), Application for Change in Accounting Method. The procedures for making an election are described in Publication 550 under the section called “Special Rules for Traders in Securities.”
If you have made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to request and receive written permission from the Service to revoke the election. Non-filing of the Form 3115 mentioned above will not invalidate a timely and valid election. To request permission to revoke your election under section 475(f), you must file a second Form 3115 and pay a fee.