Day Trading Taxes: The Ultimate Guide

We’re getting close to the ‘fun’ part of day trading: paying your taxes.

Some of you are just dipping your toe in trading waters. Others might qualify for the IRS’s tax benefits for trading.

It’s a lot, and it’s definitely less fun than pulling off a winning trade. But you ignore this stuff at your own peril.

Day trading taxes should be as big a part of your strategy as the other fees and commissions. They can make the difference between achieving your trading goals and falling short.

Quick Day Trading Taxes Disclaimer

Before we move on, our lawyers told us to share this…

This communication doesn’t establish a professional relationship for accountancy, tax advice, legal, or any other professional service. Any information presented in our communication with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) regarding any issues should not be construed as advice as it pertains to tax matters, legal matters, or any other matters. Always consult the advice of a professional licensed in your state or jurisdiction before making decisions on tax or legal matters.

Basically, we’re not doing your taxes for you. Always consult a licensed professional if you need help with that. 

Does the IRS Think of You as a Trader?

Let’s tackle the biggest variable in tax filing up front.

Qualifying for trader tax status (TTS) can open you up to greater tax benefits. But it isn’t as simple as checking a box on your tax return. Here’s how to qualify for this designation and its potential benefits.

How to Qualify for Trader Tax Status (TTS)

Trader tax status grants you more tax benefits than those who don’t qualify. The biggest difference is that you’ll be able to deduct more than $3,000 in capital losses each year.

So how do you know if you qualify? That’s the hard part — there aren’t clear guidelines. TTS traders must check all of these boxes:

• 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
• You must carry on the activity with continuity and regularity

How do you know what ‘substantial’ activity is? How about ‘continuity’ and ‘regularity’? 

Is it OK to take summers off? What if you change strategies mid-year?

While the IRS isn’t clear about TTS eligibility requirements, you can still figure out if you qualify.

But first, another word from our lawyers: 

IRS CIRCULAR 230 NOTICE. Nothing in our communications with you (including, but not limited to, website content, social media content, video content, printed material, audio content, emails, or any other content) relating to any federal tax transaction or matter are considered to be “covered opinions” as described in Circular 230.

That’s the last one. Thanks, lawyers!

What Does ‘Substantial’ Activity Mean?

Let’s tackle what ‘substantial’ activity means. Fortunately, a 2015 judgment helped to define the concept a bit more closely…

In William F. Poppe vs. Commissioner of Internal Revenue, a trader took the IRS to court over their TTS ruling. The court ultimately awarded Poppe with TTS. They based this judgment on him completing 720 trades in the year in question.

Those 720 annual trades break down to 60 per month, and about 14 each week.

Another court case helped define what counts as a ‘trade’. In Endicott vs. Commissioner of Internal Revenue, the court defined a round-trip trade as two executed trades. One trade was made in opening the position and another in exiting it.

Letting an option expire, on the other hand, does not count as a trade.

Your trades should come with the research and planning that professional trading requires. Think of it as a part-time job. That means you should be spending at least four hours on trading and research per trading day. 

Trading four out of five days per regular trading week seems like a good benchmark.

Of course, you can take breaks here and there. Just like people with a ‘real’ job, you can take vacations, sick days, and your kid’s graduation off. You can plan for those days off by averaging at least 16 trades a week.

Are You a Trader or Investor?

Holding long-term positions could jeopardize your trader status. To qualify for TTS, most of your activity should be day trades. 

You can make long-term investments. But keep those positions in a separate portfolio. You might even want to have a separate brokerage account for them.

Did You Make a Profit?

In addition to the above requirements, it helps if you made a profit in the past year. That’s all the money you made from trading after deductions.

Keep in mind that the IRS treats people with TTS as a business. And generally, businesses should be profitable for three out of five years for the IRS to consider it a profit-making enterprise… 

If it isn’t profitable in the long-term, your trading may be considered a hobby.

You might not have a five-year trading history yet, so it definitely won’t hurt if you made a profit last year.

Are You a Full-Time Trader?

Remember, your trading activity should be ‘substantial’ for TTS consideration.

No, you don’t have to be a full-time trader. But if trading is your main source of income, you’ll have an easier time qualifying for trader tax status.

Mark-to-Market Election

On top of TTS, you can make the mark-to-market election, which can give you some additional tax benefits.

To get these benefits, you have to make the mark-to-market election on April 15 of the previous tax year.

These can be big. In the Poppe case, it was ruled he didn’t properly file for mark-to-market election…

If he had, Poppe would have been able to declare his annual loss as a regular business loss. Instead, he had to abide by the capital loss limitation of $3,000. He was then able to carry over additional losses to the next year, and declare another $3,000, and so on. There’s no time limit on this carryforward.

For some traders, this works fine. But Poppe was trying to get a $1 million loss written off…

Under the $3,000 maximum, that would take a lot of years!

The Tax Benefits of Mark-to-Market

For most people, capital losses are deductible in amounts up to $3,000. As a mark-to-market trader, though, your losses are considered ‘ordinary.’ Instead of being limited to $3,000, you can deduct all of your losses.

Hopefully, you won’t have a bad enough year for this to matter much. But it happens, and the potential tax savings could mitigate your losses.

You’d also be exempt from the wash-sale rule (more on that later).

There are other benefits to mark-to-market election, such as lower capital gains rates on futures.

These advantages come with added complexity.

If you’re a new or low-volume trader, mark-to-market might not apply to you. Still, it’s good to be familiar with it in case your trading activity increases.

For full-time and high-volume day traders: Know the steps you can take to potentially save some money when tax day rolls around.

Separate Your Long-Term & Short-Term Investments

Before you file taxes, you need to understand the difference between long-term and short-term investments.

Long-term investments are positions you hold for over a year. They are taxed at a much lower rate.

You hold short-term investments for less than a year. They’re taxed at the normal income rate.

Regular tax rate for most taxpayers ranges from 22–37%. 

Compare that to a long-term tax rate of 15%. It goes down even lower under a certain threshold.

To benefit from lower long-term tax rates without sacrificing your TTS designation, you can use separate long-term and short-term portfolios. This can make filing taxes easier and help you get all the tax benefits you qualify for.

The IRS also requires separate brokerage accounts for long-term and short-term investments in the same stock.

What Are Capital Gains & Losses?

Capital gains are the profits you make by buying or selling a security. Capital losses are the opposite.

Short-term capital gains are taxed at the regular income tax rate. Again, losses are deductible — but only up to $3,000 if you don’t make the mark-to-market election.

Now, how about those forms…

If you don’t make the mark-to-market election, you need to report your capital gains and losses on Form 8949 and Schedule D.

You also need to report your trading expenses on Schedule C. This doesn’t include any revenue and would automatically show a loss… Leave a statement on the form explaining that your net trading gains are reflected on Schedule D.

If you make the mark-to-market election, you can report all of your capital gains and losses as business property on Part II of IRS Form 4797.

Whew. Moving on…

Terms You Should Know

Confused by tax terminology? Let’s brush up on a few key terms…

Earned Income

This is any money that you make from a job — part-time or full-time. Earned income includes salary, tips, bonuses, etc…

It does NOT include trading income.

That means you don’t have to pay self-employment taxes. This sounds nice… until you realize you aren’t contributing to your social security account. And that means you may not be eligible for retirement benefits.

Investment Income

Investment income includes interest, dividends, royalties, and annuities. It’s any income from property held for investment before deductions.

Capital gains are typically not treated in the same way.

Cost Basis

This is the amount you pay for a security, plus any commissions.

Your cost basis is the value used to measure gains and losses. If a position’s value is greater than your cost basis by the time you close your position, it’s a capital gain. If it’s lower than your cost basis, it’s a capital loss.

Wash-Sale Rule

As I said earlier, this is another benefit of making the mark-to-market election. You can get exempted from the wash-sale rule.

A wash sale is buying or selling a security at a loss… Then buying a ‘substantially identical’ security within 30 days of the sale.

The wash-sale rule states that you can’t claim a loss on the sale of a security in a wash sale. Being exempt allows you to spend less time bookkeeping and more time trading.

Your Biggest Tool for Becoming a Professional Trader

The IRS has a lot of boxes to check and hoops to jump through…

But the biggest part of being a real trader is your preparation, not the outcome.

The trading platform I use, StocksToTrade, has all the tools I need for trading — in one place. It’s got a state-of-the-art stock screener, a great news scanner, tailored alerts services, and awesome charting…

Basically, everything day traders need to succeed!

Try it today — your first 14 days are only $7.

The Bottom Line

Tax day is stressful for nearly everyone. You want to save as much money as possible… but you don’t want to make any mistakes that spell trouble with the IRS.

Day traders have to consider factors that most people don’t. So when it’s time to file your taxes, you need to know how to report trading income, what you can deduct, and how to take advantage of tax benefits.

Our #1 tip for day trading taxes? Be informed and consult a tax professional. Don’t hesitate to get guidance for your specific circumstances.

Are you ready for tax season? How do you manage your day trading taxes? Share a comment below!