If you invest, whether you’re considered an investor or a trader can have a significant impact on your tax bill. Do you know the difference?
Investors
Most people who trade stocks are classified as investors for tax
purposes. This means any net gains are treated as capital gains rather than
ordinary income.
That’s good if your net gains are long-term (that is, you’ve
held the investment more than a year) because you can enjoy the lower long-term
capital gains rate. However, any investment-related expenses (such as margin
interest, stock tracking software, etc.) are deductible only if you itemize
and, in some cases, only if the total of the expenses exceeds 2% of your
adjusted gross income.
Traders
Traders have it better in some situations. Their expenses reduce
gross income even if they can’t itemize deductions and not just for regular tax
purposes, but also for alternative minimum tax purposes.
Plus, in certain circumstances, if traders have a net loss for
the year, they can claim it as an ordinary loss (so it can offset other
ordinary income) rather than a capital loss. Capital losses are limited to a
$3,000 ($1,500 if married filing separately) per year deduction once any
capital gains have been offset.
Passing the trader test
What does it take to successfully meet the test for trader
status? The answer is twofold:
1. The trading must be “substantial.” While
there’s no bright line test, the courts have tended to view more than a
thousand trades a year, spread over most of the available trading days, as
substantial.
2. The trading must be designed to try to
catch the swings in the daily market movements. In other
words, you must be attempting to profit from these short-term changes rather
than from the long-term holding of investments. So the average duration for
holding any one position needs to be very short, generally only a day or two.
If you satisfy these conditions, the chances are good that you’d
ultimately be able to prove trader vs. investor status. Of course, even if you
don’t satisfy one of the tests, you might still prevail, but the odds against
you are higher. If you have questions, please contact us.
