Filing a tax return is the first step in a potentially adversarial relationship with the IRS. The preparation of a tax return is both a science and an art — though if your return is trending more toward art, it may be a red flag. While a filed return must be in conformity with the tax laws in all respects, how the information contained in the return is just as important. During the years, the IRS has challenged many taxpayers who treated themselves as day traders. Knowing in advance both the benefits and risks of this designation, what steps to take proactively, and what to do in the event of an audit will serve you well and provide peace of mind.
Those trading in securities have had great incentive to classify themselves as a trader. By default, buying and selling publicly traded securities is an investment activity, with gains and losses being capital in nature, and related expenses being deducted as an itemized deduction.
The upside to investor treatment is that any gains are treated as capital gains, with positions held for more than one year receiving the favorable long-term capital gains tax rate of 15% (or 20% depending on your tax bracket). But this is of no use to the high-volume trader who rarely holds anything for more than a day, let alone a year.
The downside to investor treatment is that net losses are limited to a $3,000 deduction each year ($1,500 if married, filing separately). Net gains are typically all short-term, receiving ordinary income treatment.
Yet, the investment related expenses are taken as a miscellaneous itemized deduction. These deductions are reduced by 2% of your adjusted gross income (AGI) are of no benefit if you are in the alternative minimum tax.
Interest the investor incurs to finance trades, whether it is margin interest or borrowed from some other source, is limited to net investment income. This includes interest, dividends and capital gains. Such interest is treated as an itemized deduction, though not subject to the 2% phase out discussed above. Investment interest expense that cannot be used in the current year may be carried over to future years.
Because trading profits add to AGI, phase outs of other tax breaks are magnified. Student loan interest, higher education credits, special real estate rental loss allowance, personal exemptions, miscellaneous itemized deductions and the overall allowable itemized deductions are all adversely affected. When AGI exceeds a threshold amount ($125,000 for married, filing separately; $250,000 filing jointly; $200,000 for single and head of household), the lesser of net investment income or the amount over this threshold is subject to an additional tax of 3.8%. This net investment income tax is part of the Affordable Care Act. Whether this gets repealed remains to be seen. The harsh reality is that any true economic gain for the year ends up being taxed at a very high rate.
As a basic example, assume an investor is in the
28% tax bracket and is in the alternative minimum tax. He is a single filer with AGI of $340,000; nets $100,000 of short-term capital gains as his only investment income (no wash sales) and incurs $20,000 of various trading expenses during the year. He will pay federal tax of $31,800, including the net investment income tax. In reality, that’s an almost 40% effective tax burden on the true economic gain of $80,000.
That is how the tax code is structured.
An additional wrinkle for investors is the wash sale rule. A wash sale occurs when a security is sold at a loss and the same or substantially identical security is purchased 30 days before or after that trade. The impact of the wash sale is that the loss is not deductible, but is added to the cost basis of the related security. Until that security is sold at a gain, or at least 30 days elapses if sold at a loss, the original loss recognition is deferred.
The impact to the investor who makes hundreds, if not thousands, of trades during the year is that it is possible for the net transaction income reported on the tax return to be substantially higher than the true net income. As the wash sale rule only applies to losses, the tax code gladly takes into income all of the gain transactions, but loss transactions are subject to this limitation.