Online Trading Academy Lessons from the Pros 04/19/05: What's Trader Tax Status Worth? Here's How You'd Fare Without It!

Traders Accounting: What's Trader Tax Status Worth? Here's How You'd Fare Without It!

What's Trader Tax Status Worth? Here's How You'd Fare Without It!
By Jim Forrester, CPA

Traders Accounting provides tax consulting, entity formation, tax preparation and 401(k) services that help you efficiently establish and maintain your trading business. They teach you the IRS rules that allow you, as a trader, to deduct the widest range of business expenses and fringe benefits available to business owners. The goal is to help you lower your taxes, save you time, and maximize the benefits of your trading business. Visit their web site at: www.tradersaccounting.com

What's Trader Tax Status Worth? Here's How You'd Fare Without It!

The Internal Revenue Service has two tax classifications for individuals who buy and sell securities, mutual funds, options, futures, commodities and other derivatives: trader and investor. The minority who trade for a living under the IRS definition are classified as traders and afforded an attractive menu of tax breaks. The majority who trade part-time, either in addition to fulltime W-2 employment or as a retirement hobby, do not enjoy the
tax advantages that accompany trader status.

So how do the two match up come tax time? If your trading left you in the black, you could save thousands. If your trading resulted in a substantial loss however, the ability to write off that loss in the year it occurred could result in a windfall of $20,000 or more.

How Traders Trump Investors

As a trader, you trump investors in two main ways: you can fully deduct all of your trading expenses and you can write off 100% of your losses in one year (provided you elected the mark-to-market accounting method).

Investors who itemize their deductions on Schedule A are limited to a handful of deductible investment expenses, including legal and accounting fees, investment counseling and advice and investment newsletters. These must be listed as miscellaneous itemized deductions and can only be deductible to the extent they exceed 2% of adjusted gross income.

As a trader however, you can deduct all of your business-related expenses, including your data feed, dues and subscriptions, equipment, utilities, seminars, transportation, travel and entertainment, and the home office deduction if you work from home.

So far, the IRS has left further delineation in the hands of the tax court, whose rulings tend to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Expense Deductions Add Up Fast

Here's how the additional expense deductions would benefit Janet Trader compared to Johnny Investor if both had identical trading gains and business expenses. Note that Johnny Investor is subject to the 2% threshold for the few deductible expenses he is qualified to claim:

Total household income: $140,000
Trading profits: $40,000
Trading expenses: $24,230

Janet Trader's tax savings: $7,269
Johnny Investor's tax savings: $1,644
Benefit of trader tax status: $5,625

Risk Insurance: The Capital Loss Deduction

When it comes to covering losses, traders fare even better: the IRS allows traders who elected mark-to-market to write off their entire loss in one year. You can even apply the loss to taxable income from past years and generate a tax refund!

Investors, meanwhile, have a maximum allowable net capital loss of $3,000 in any tax year. That means if you lost more than $3,000, your only recourse is to carry over the remaining balance until it's used up, but again, only to a maximum of $3,000 a year.

Here's how a $40,000 loss would impact Janet Trader and Johnny Investor. Note that Janet Trader was able to offset her regular $100,000 income with her $40,000 loss, while Johnny Investor was limited to the $3,000 capital loss deduction:

Total household income: $140,000
Trading loss: <$40,000>
Trading expenses: $24,230

Janet Trader's tax savings: $19,269
Johnny Investor's tax savings: $984
Benefit of trader tax status: $18,285

Investors also face another limit: they may only deduct investment interest up to the amount of their net investment income, defined as total investment income (earnings, interest, dividends and royalty income) less the deductible investment expenses previously discussed. Any investment interest that exceeds that cap is non-deductible, but may be carried forward to future tax years.

One of the best ways to secure and protect your trader tax status is to trade as a business entity. The IRS treats business filers in a far more consistent and advantageous way than it does individual traders. To find out what entity would work best for your trading business sign up for our Tax Action Plan service. This service is free and completely confidential. To signup go to http://www.tradersaccounting.com/taxplan.asp

Jim Forrester, CPA is the Tax Director of Traders Accounting, the nation's leading provider of tax consulting, entity formation, tax preparation and 401(k) services to the trading industry. Traders Accounting teaches traders how to properly set-up their trading business and take advantage of all the money-saving tax strategies available to home-based businesses. Explore the website that Forbes has declared "Best of the Web" for six straight years and find out exactly how to make your trading into a 'business' and receive tax breaks and tax deductions worth up to $25,000 each year. Visit www.tradersaccounting.com for more info.