Trading can be taxing

So you opened a trading account last year and now it’s time to file your taxes. While tax filing for traders isn’t likely to be painless, there are a few simple steps that can make it less, well, taxing.

First, set your sights on all available tax-related breaks by attempting to qualify for trader tax status. According to Robert A. Green, CPA and CEO of Green & Co., the majority of traders still don’t take advantage of this option, which he says can save the average trader $8,000. Second, today’s trading world includes many different instruments that may be taxed differently. Know where your tax breaks apply.

Making the grade

Qualifying for trader tax status is more difficult for part-time traders vs. full-time traders, Green says. And although qualifying can be difficult, he notes traders shouldn’t be afraid to try it.

Green outlines the two-part test for trader tax status qualification: 1) your trading activity must be substantial, regular, frequent and continuous; and 2) you must seek to catch the swings in the daily market movements and profit from these short-term changes rather than profiting from long-term holding of investments. He says that a simple definition is that you spend more than four hours per day trading, every market day. Traders should support their claim of trader tax status by adding a detailed footnote to their tax return. With summary reporting for futures on Form 1099, which is prepared by your broker, Green says accounting is a snap for pure futures traders. Form 1099-B shows “Aggregate Profit or Loss,” which includes realized and unrealized gains and losses on futures (see “Rules of the road,” right). Enter that summarized amount on line 1 of Form 6781; which is used to report gains and losses from futures contracts. Schedule D includes a box for the net from Form 6781.

“Keep in mind that losses from capital gains (Schedule D) and futures (6781) both count toward the $3,000 annual loss allowed by the IRS. Net losses above $3,000 can be carried over to future tax years,” says Cameron Routh, senior vice president at Scivantage.

TAX TREATMENTS

The number of types of derivatives contracts has changed dramatically from when futures tax law was first written. Here’s a rundown how each is taxed or viewed by the IRS:

U.S. futures contracts: The best news for futures traders is U.S. futures contracts still are classified as Section 1256 contracts, which get the preferential 60/40 long-term/short-term capital gains tax treatment, wherein 60% of gains are considered long-term gains, taxed up to 15%, and the remaining 40% of gains are considered short-term gains, taxed up to 35%. The effective maximum tax rate for gains on U.S. futures is only 23%. The 15% long-term maximum tax rate x 60% = 9%, and the 35% short-term maximum tax rate x 40% = 14%. The two added together equals the effective maximum rate of 23%. This is 12% lower than the current maximum tax rate of 35% on short-term capital gains on securities (see “It can make a difference,” below). Single stock futures and stock options are treated like stocks, which fall under the securities category and the higher tax rate.

Foreign futures contracts: Taxing foreign futures contracts is a little more complicated. Trading futures contracts listed on non-U.S. futures exchanges, in most cases, does not qualify for the preferential Section 1256 tax treatment. Even though an exchange’s contracts are approved for trading by U.S. customers, that exchange must get separate approval from the Treasury Department for 1256 tax treatment.

Robert Hartnett of Rothstein Kass says, “Gains and losses are taxed as either ordinary income under Section 988 or as short-term capital gain, depending on the specific contract. If certain foreign futures or forward commodity contracts are held for longer than six months, such contracts could be taxed wholly as long-term capital gain and benefit from the reduced tax rates on such gains.” Hartnett also notes that foreign futures contracts are generally not marked-to-market for tax purposes at year end. “If a trader has significant OTE (open trade equity) on foreign futures positions open at year- end, the trader could benefit from not currently being taxed on such OTE. If the OTE was from Section 1256 contracts however, the OTE would be marked-to-market at year-end and taxed currently,” he says.

In March 2007, ICE Futures Europe acquired an IRS ruling that resulted in all commodity futures contracts and futures contract options entered into on the ICE on or after April 1, 2007, to be considered section 1256 contracts that receive 60/40 tax treatment. The ICE ruling is important to keep in mind for this year’s filing, because if you traded ICE futures contracts in 2007 before April 1, those contracts will not be classified as Section 1256, but rather as capital assets. Under Section 1222, the gain or loss would be considered 100% short-term in most cases unless the contract was held for longer than six months.

“Now that the ICE contracts are considered Section 1256 contracts, these contracts will be marked-to-market and treated as if they were sold at year-end,” Hartnett says. He also says other foreign futures exchanges without such an IRS ruling, such as Liffe and Eurex, if they believe they meet the standards necessary to be considered a qualified board or exchange, should request an IRS ruling so contracts on those exchanges can be treated as Section 1256 contracts.

Foreign currency contracts: Don’t assume that foreign currency forward contracts are taxed as Section 1256 contracts because, as Hartnett says, “absent certain tax elections, that is not the case. Foreign currency forward contracts that are also traded as a U.S. regulated futures contract are generally marked-to-market and taxed as ordinary income at a taxpayer’s marginal tax rate.” To get preferential tax treatment under Section 1256 for such contracts, he advises traders to make an election such as the Section 988(a)(1)(B) election prior to or when entering into such contracts.

COMBINED PORTFOLIOS

Traders who have securities, futures and forex combined into one account, or who have trading accounts in foreign countries, face unique challenges, Green notes. “They are all treated differently for tax purposes. Foreign accounts are often held in foreign currencies, [creating] further accounting and tax complications. There is a tax reporting method allowed in some cases using average foreign exchange conversion rates for the tax year. Although this method is often easier accounting-wise, it’s not always preferable tax-wise,” Green says. If you fall into this category, it’s important to see a tax professional who specializes in the trader tax arena, as they are more able to help sort out these issues.

AMT PLANNING

Green notes the importance of Alternative Minimum Tax (AMT) planning with possible changes coming out of Congress in the coming year. The AMT, part of the Tax Reform Act of 1969, was originally intended to target a small number of high-income taxpayers who could claim so many deductions they owed little or no income tax, but now since AMT is not indexed for inflation, it’s snagging many middle-income taxpayers too. Congress is attempting to repeal the AMT tax, and to pay for it by raising tax rates on upper-income taxpayers.

“By accelerating income into the current tax year and deferring AMT tax deductions into the following year, taxpayers can save taxes on two ways at once,” Green says. Futures traders trigger AMT easily, as with 60/40 treatment on Section 1256 contracts, their maximum rate of 23% is far below the AMT rate, Green notes. He adds that “no current tax bill has threatened to repeal 60/40 tax breaks for futures traders, but if AMT is eliminated, Congress may revisit the tax break.”

To avoid AMT, Green suggests preparing an estimated tax return before year-end to see if you trigger it. “For regular income tax purposes, it’s smart to prepay all state income taxes before year-end for an additional tax deduction and related reduction of tax. But if you trigger AMT, prepaying some or all of your state income taxes is a big mistake, since state taxes are not deductible for AMT. Instead, you can pay just enough fourth-quarter estimated state income taxes before year-end to equal the AMT threshold and pay the balance when due in the following year. That’s either Jan. 15 (for the estimated income tax safe harbor exception) or by the April 15 tax return or extension due date,” he says.

Green says to be honest with the IRS, but not intimidated by them. If you qualify, apply for trader tax status and defend your right to it.

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