Taxes Trading Capital Gains Losses Tax Guide
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Mysteries of Trader Tax Status by MetaStock
Just because you call yourself a securities trader doesn't make you one in the eyes of the Internal Revenue Service.
In fact, Uncle Sam is predisposed to consider you merely a hyperactive investor-and thus deny you a more favorable tax status-unless you meet a number of criteria that are frustratingly open to interpretation.
You read that right: the tax code contains no actual definition of trader tax status.
Instead, the IRS has issued guidelines the tax courts have expanded upon with case law, most of which denied tax appeals by traders.
What we're left with is a blurred image, like a photograph of a trader taken from a speeding car.
According to the IRS, to qualify as a trader:
. 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.
To help determine if you meet these three tests, the IRS considers these qualifiers:
. Typical holding periods for securities bought and sold;
. Frequency and dollar amount of trades during the year;
. Extent to which you pursue trading to produce income for a livelihood, and
. Amount of time you devote to the activity.
Swoosh, right? What is "substantial" activity? "Continuity and regularity?" And what's an acceptable holding period? Is a week too long? A month?
We know who investors are: They're our hardworking neighbors who buy securities and hold them for such long-term goals as a college fund or retirement.
Traders, on the other hand, buy and sell securities solely to take advantage of short-term market changes. Your profits come from price swings, not dividends and interests. Since your holding period is brief, often a day at most-hence the term "day trader"-there's no need to perform due diligence on the companies you trade.
Who cares how the IRS classifies you? You do!
Investors are subject to the 2% threshold for deductible investment expenses - and hence cannot write off most of their expenses-and are limited to a $3,000 capital loss deduction.
But as a trader, you write off 100% of your expenses, and if you elect the mark-to-market accounting option, you can offset all of your losses against your earned income.
Three Steps to Claim and Protect Your Trader Tax Status
Step 1: Prove beyond doubt you are a bona fide trader - that is, you "seek to profit from daily market movements."
The best way to accomplish this is by showing a pattern of high trading volume and short holding periods. Keep your personal investments well separated from your trading business. The IRS is looking for "earnest intent;" that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades.
Step 2: Clear the "substantial activity" hurdle.
The hallmarks the feds are looking for here are "frequent, regular and continuous" trading. That means volume. One court case ruled that 330 trades a year was sufficient to warrant trader status. The feds need to know that you approach this as a business, not a hobby. Fail to convince them of that and you're back in investor-land.
Step 3: Trade with "continuity and regularity."
If you want trader tax treatment, it only stands to reason that you must actually be in - and remain in - the business of trading.
Here's where the IRS is looking for a healthy flow of trades, significant dollar amounts, short holding periods - all the signs that you are at least attempting to make a living as a trader.
If you take the summer off or show other gaps in your trading, the IRS will be disinclined to grant you trader status. If you're a newbie and flame out after nine months, while it seems unfair, the IRS has made it clear: no trader status for you.
Once you obtain trader tax status, you're not entirely in the clear. Owing to the capricious nature of appellate rulings and the ever - evolving tax code, there are no guarantees the trader status you enjoy today might not be gone tomorrow.
One good way to secure your trader status is to trade under the umbrella of a business. That's not only where the most lucrative tax advantages reside, but a legal entity such as a general partnership, Limited Liability Company or C corporation sends a strong message to the IRS that yours is an earnest and legitimate business enterprise worthy of trader tax status.
My recommendation is for you to maintain a day timer devoted completely to tracking the amount of time you spend each day on your trading activities. If you are audited by the IRS chances are it will be two or three years after you have filed your taxes. The day timer will service as proof of how many hours you spend each week on your trading activities.
Investing Trading Capital Gains Losses Tax Guide
Capital Gains and Losses. What's a capital asset, and how much do I have to pay when I sell? Find out how to report your capital gains and losses on your taxes.
What is a capital gain?
A capital gain is what the tax law calls the profit when you sell a capital asset, which is property such as stocks, bonds, mutual fund shares, and real estate.
What's the difference between a short-term gain and a long-term gain?
A very big difference. The law divides investment profits into different classes determined by the calendar. Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum tax rate; long-term gains are taxed at a lower rate.
What is the holding period?
That's the period you hold the property before you sell it. When figuring the holding period, the day you buy property does not count, but the day you sell it does. So, if you bought a stock on April 16, 2006, your holding period began on April 17. Thus, April 16, 2007, would mark the end of the first year. If you sold on that day, you would have a short-term gain or loss. A sale on April 17 would produce long-term results, though, since you would have held the asset for more than one year.
How much do I have to pay?
The tax rate you pay depends on whether your gain is short-term or long-term.
Short-term profits are taxed at your maximum tax rate, just like your salary, up to 35%.
Long-term gains are treated much better. Long-term gains are taxed at a flat 15% except for taxpayers in the 10% or 15% bracket. For low-bracket taxpayers, the long-term capital gains rate is just 5% for 2007 gains and drops to 0% on January 1, 2008. (There are exceptions, of course, since this is tax law: Long-term gains on collectibles-such as stamps, antiques and coins-are taxed at 28%, unless you're in the 10% or 15% bracket, in which case the 10% or 15% rate applies; and gains on real estate attributable to depreciation - since depreciation deductions reduce your cost basis, they also increase your profit dollar for dollar - are taxed at 25%, unless you're in the 10% or 15% bracket. And stocks sold by kids under 19-under 24 if they don't pay half their support-won't qualify for the 0% rate, beginning in 2008. Gain on stocks they sell will be taxed at their parents' rate.)
What is a capital loss?
A capital loss is a loss on the sale of a capital asset such as a stock, bond, mutual fund or real estate. As with capital gains, capital losses are divided by the calendar into short- and long-term losses.
Can I deduct my capital losses?
Losses on your investments are first used to offset capital gains of the same type. So, short-term losses are first deducted against short-term gains and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain. So, for example, if you have $2,000 of short-term loss and only $1,000 of short-term gain, the extra $1,000 of loss can be deducted against long-term gain. If short- and long-term losses exceed all of your capital gains for the year, up to $3,000 of the excess loss can be deducted against other kinds of income, including your salary, for example, and interest income.
For more information, see IRS articles Reporting Capital Gains and Losses and Ordinary or Capital Gain or Loss.
Tax Strategies for Investors and Traders
The volatile securities markets make year-end planning challenging for investors. As the year-end approaches, you should consider the following moves to make the best tax use of paper losses and actual losses from your stock market investments.
Sell at a loss to offset earlier gains.
If you have taken down gains earlier in the year from sales of stock held for held for more than one year (long-term capital gains) or from sales of stock held for one year or less (short-term capital gains), look through your portfolio to see about selling some of those shares that now show a paper loss. The best tax strategy is to sell enough of these to shelter your earlier gains and generate a $3,000 loss. Selling to yield this amount of loss is beneficial from a tax perspective because a $3,000 capital loss (but no more) can offset a similar amount of ordinary income each year.
For example, if you have $10,000 of capital gain from the sale of stocks you sold earlier this year and you also have several losing positions, including shares in XYZ Corp., in which you are showing a $15,000 loss. From the tax viewpoint, you should consider selling enough of your XYZ shares to recognize a $13,000 loss. Your capital gains will be offset entirely, and you will have a $3,000 loss to offset a that amount of ordinary income.
If you believe these shares showing a paper loss (the XYZ shares) still have the potential to turn around and eventually generate a profit, you can sell and then repurchase the shares without forfeiting the loss deduction only if you avoid the wash-sale rules. This means you must buy the new shares outside of the period that begins 30 days before and ends 30 days after the sale of the loss stock. However, note that if you expect the price of the shares showing a paper loss to rise quickly, your tax savings from taking the loss may not be worth the potential investment gain you may lose by waiting more than 30 days to repurchase the shares.
You can use earlier year losses to offset gains you would benefit from taking. If you have capital losses on sales earlier in the year, consider whether you should take capital gains on some stocks that you still hold. For example, if you have appreciated stocks that you would like to sell, but don't want to sell if it will cause you to have taxable gain this year, consider just selling enough shares to offset your earlier-in-the-year capital losses (except for $3,000 of those which can be used to offset ordinary income). You should consider selling appreciated stocks now if you believe those stocks have reached (or are close to) the peak price and you also believe that you can invest the proceeds from the sale in other property that will give you a better rate of return in the future.
For example, if you have $20,000 of long-term capital losses from your previous year stock transactions, and $4,000 of short-term capital gains, and you don't have other transactions involving securities or other capital assets for the previous year, you'll end the year with a $16,000 long-term capital loss, of which only $3,000 can be used to shelter ordinary income. The $13,000 balance of the loss could be used to offset gain on appreciated stock that you want to sell but which you would not sell now if you had to pay tax on the gain recognized on the sale.
If this applies to you, and your holdings showing a paper gain consist of stocks you haven't held for more than one year, as well as stocks you have held for more than one year, you should consider selling those stocks on which you will have short-term gain first, and then stocks that would yield long-term gain. This way, you'll be in a better position to wind up with gain taxed at favorable rates when you sell other stocks with paper gains. To the extent possible, you should also try to use long-term capital losses to offset short-term capital gains. This can be done, however, only if the total of your long-term capital losses is more than your long-term capital gains. Deferring long-term capital gains until next year is one way of achieving this goal.
As individual taxpayers can carry over capital losses indefinitely, there is no reason to sell appreciated stocks just to have offsetting gains. If you don't have a better investment for the proceeds of a sale of these stocks, don't sell them. You can carry over your capital losses to next year when you may have a better chance to make use of the losses. You can also offset another $3,000 of the carried over losses against ordinary income next year (and in succeeding years if the full amount of the capital loss carryover is not used next year).
When should gain on the sale of stock this year be taken this year even if you don't have offsetting losses? A previous year sale of paper-gain stocks you have held for more than one year may make sense (even if you haven't recognized losses) if you will be in the 15% bracket this year, for example, due to large business net operating losses that will offset most of your ordinary income, but expect to be in the 28% bracket in the following year. By selling this year rather than next, part or all of the gain will be taxed at a maximum rate of only 10% (instead of 20%).
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