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Trader Status and U.S. Income Taxes – Part Two

[Ed: Member karmcon submits the following important information. Part One is available here.]

Pros and Cons of electing “trader status”

Assuming the latency effect is in play I will discuss the Cons first.

CONS

1. Must “mark-to-market” most holdings at 12-31 each year.  This means you recognize any gain or loss on the securities in your virtual portfolio as if you sold them on December 31.  (You now know where the term “tax selling” really was derived as stocks and options with gains, not just losses, are sold off in December to prevent the taxation of phantom gain.)  The basis of the asset is adjusted for the recognized gain or loss and is taken into consideration when the asset is sold.  For example, you have 50 Jan 08 contracts that you purchased in November 2007 for 10000.  On December 31 2007 they are worth $12000.  You recognize $2000 of gain on your 2007 tax return and increase the basis by $2000.  In January 2008 you sell the options for 11000.  You then realize a $1000 loss on your 2008 tax return. (10K orig cost + 2K recog gain = 12K. 11K proceeds on sale – 12K adj, basis = (1K).)

2. Gains and losses are separated into (typically) four categories as you may be a trader in some securities and hold other securities for investment (see (a) below). The type of investment you are buying or selling and the related gain/loss is another category of “trader” gain or loss (see (b) below)..  Hedging transactions comprise the third category (see (c) below).  The fourth category is probably the only category you thought existed, the gain or loss from sales of equity.

  • Investment gains and losses:  The special rules for traders do not apply to securities held for investment (For example, you may buy Sirius stock in expectation of a buy-out sometime in the future (future being unknown, could be 6 months or 5 years). A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day he or she acquires them.  (A technical requirement that often times is done at the end of the year after you realize you are holding the stock for the long haul even if at the time of purchase you hadn’t planned it that way.)   This type of gain or loss is classified as if it was business property and is reported on Form 4797.
  • 1256 Contracts and related gain or loss upon disposition:  Generally, this is gain or loss on non-equity options (DIA’s and QQQQ;s for example) and  regulated futures contracts.  Specific definitions apply so consult with a tax professional if you trade in the futures or Forex markets.  The gain or loss on the sale of 1256 contracts under the marked to market system, 60% of your capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss. This is true regardless of how long you actually held the property.  The identification of this type of gain or loss as being from a “256 contract” must be done throughout the tax as well as at December 31 of each tax year.. Form 6781 us used to report the gains or losses   If you disposed of regulated futures or foreign currency contracts in 2006 (or had unrealized profit or loss on these contracts that were open at the end of 2007), you should receive Form 1099-B, or an equivalent statement, from your broker.  This rule applies regardless if you make the election!!
  • Hedging transactions:  The marked to market rules, described earlier, do not apply to hedging transactions. A transaction is a hedging transaction if both of the following conditions are met: (1)You entered into the transaction in the normal course of your trade or business primarily to manage the risk of: (a) Price changes or currency fluctuations on ordinary property you hold (or will hold), or (b) interest rate or price changes, or currency fluctuations, on your current or future borrowings or ordinary obligations. (2) You clearly identified the transaction as being a hedging transaction before the close of the day on which you entered into it.  The gain or loss from hedging transactions is reported in the tax year incurred and on Schedule C (Business gain or loss).
  • Equity options:  This is any option: (1)  to buy or sell stock, or (2) That is valued directly or indirectly by reference to any stock or  narrow-based security index.  (Narrow based implies a small number  of stocks comprising the security index.)  This net gain or loss is reported on Schedule C (Business Gain or Loss).

There are also additional rules and regulations regarding limitations of losses and ability to carryback losses.  Consult a tax professional.

Cons Conclusion:  By now I am sure there is some confusion and/or frustration occurring, but if you use a competent tax professional, your only job should be to mark the stocks held for investment, transactions related to stock index gains or losses and hedging transactions.  If you do this when you receive your monthly statement and place in 2007 tax file you will save yourself time and money come April 2008.  (Your accountant will also love you.  He/she will love you more if you total the different categories of gain/loss for the year and calculate the phantom gain or loss as of December 31. He/She can do this for you, but paying $100-$300 per hour to do something this mundane doesn’t make much economic sense.  Will also save you from telephone calls from your tax professional and from relying on 12-15 month old long term memory.)

PROS

This is the good stuff.

  1. After making the tax trader or mark to market election your profession is officially sanctioned (for federal income tax purposes) as being a securities trader.
    a.  Capital gain loss limitations do not apply to this type of income or loss.
    b.  Ordinary business deductions offset dollar for dollar any income or increase any loss from the net gain/loss on your security transactions.  (1) Margin interest, dues (Phil’s Stock World, for example), newsletter subscriptions, office supplies, depreciation on off9ce equipment and professional fees are just some of the expenses that qualify for deduction.  Many of these expenses are not allowed or are limited due to phase outs if the election is NOT made.  (2) Travel and Entertainment and Home Office deductions are allowable in certain cases, but I would caution aggressive dollar deduction amounts.  Consult your tax professional.
  2. The 30 day “Wash sale” loss limitation rules are not applicable if you have made the tax trader election.
  3. If, after all deductions are subtraced from the net income from the sale of secutities results in net profit, you are NOT subject to self employment tax. 
  4. Subject to a host of rules and regulations, if you incur a large loss from your business as a trader you can offset all other income you have from other sources.  If your loss exceeds all other income you may have a net operating loss that may be carried back 3 years to offset the income reported.  Any carryback offsetting income will result in a refund of the tax originally paid on the reduced taxable income.   Consult a tax professional.

PROS SUMMARY:  YOUR TAX BILL WILL BE LOWER IF YOU MAKE THE ELECTION (a majority of the time, that is…..for proof calculate your taxes both ways)

Once again I will stress that statements or opinions expressed here are solely mine.  The rules and regulations cited are not to be considered all inclusive and you should consult your tax professional before making any income tax decisions that could affect your individual financial situation.

karmcon


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  1. Phil, can we put these two posts of Karm’s in a special place where we can have them as reference? It is going to take me a couple of readings to digest them. Thanks again Karm.


  2. Thanks for your time and expertise, karmcon. I’m with size, it’s gonna take me more than once…not so hot with accounting and tax issues. But it IS clearer than mud, much improved from my prior (nearly complete) lack of knowledge on this subject. As I get it after one reading, it may require slightly more complex bookkeeping, but will save money in the long run by allowing more deductions…

    Thanks again,
    N


  3. Great summary!!! Thanks again for all your efforts.


  4. My pleasure…

    nltd……Excellent summary!! That’s it in a nutshell (+/- a couple of hundred variables depending on the individual) I will guess Phil’s accountant either loves or hates seeing Phil walk into the office. It all depends on how Phil arranges his data. (I have a feeling Phil’s data is pretty well organized and complete, prob due to Tina’s efforts lol) Like anything else, if you take 10 minutes a month it saves you at least double the 2 hours it took on an annual basis. Your time is valuable too!