By William R. Simpson, Dean W. DiGregorio, and John L. Crain
Market Volatility Is Not the Only Issue
The tax treatment of online and day trading for federal income tax purposes depends on the individual’s classification: investor, trader, or mark-to-market trader. Qualifying as a trader is difficult because one must be active in the securities markets on a daily basis and attempt to profit from short-term swings in security prices. Many online investors fail this test, but some day-traders (most of whom are also online investors) meet the standard.
Once classified as a trader, the election of the mark-to-market rules seems to offer many advantages for taxpayers willing to take an aggressive position. Mark-to-market traders’ net gains are taxed at ordinary rates rather than at lower capital gain rates. On the other hand, mark-to-market traders’ losses are not subject to the deduction limitation on net capital losses. Other advantages include being able to deduct margin interest expense, being able to deduct related expenses as business expenses, and, in profitable years, possibly being able to deduct home-office related expenses. Also, even though net gains will be treated as ordinary income, mark-to-market traders are not subject to the self-employment tax.
As more investors become actively involved in the stock market, mostly because of the convenience of online research and trading, they and their advisors face a host of tax-related issues. Online trading refers to the practice of buying stocks and other investment vehicles on the Internet as opposed to the more traditional approach of using a stockbroker. Many brokerage companies now specialize in online trading, and many full-service brokers have entered the field as well.
While online trading can be done on a “buy and hold” basis, the ability to trade online has resulted in the day trading phenomenon. Day trading is the practice of buying and selling securities on a daily basis. Often day traders take and exit a position within a matter of hours; technology stocks and initial public offerings (IPOs) are particular favorites for this approach.
While day trading can be done over the phone through a conventional stockbroker, it is primarily performed online. Day traders can take a buy-and-hold approach, but most of them seek to take advantage of short-term market fluctuations. This type of activity may qualify some day traders as traders rather than investors for federal income tax purposes.
Defining Terms: Trader versus Investor
Because the federal tax code does not include definitions of “trader” and “investor,” taxpayers must rely on previous court decisions. With a few exceptions, the courts have been fairly consistent regarding the distinction.
First, the activities most individuals engage in will typically be classified as investment activity. For example, in Higgins [25 AFTR 1160, 312 US 212 (1941, S. Ct.)], the practice of holding stocks on a long-term basis and collecting dividends, interest, and capital gains was defined as that of an investor. This was the Supreme Court’s opinion even though the activities were performed in a businesslike manner (e.g., detailed records were maintained for a large estate) and with “continuous, repetitious, and regular” activity. In Moller [52 AFTR2d 83-6333, 721 F2d 810 (1983, CA Fed. Cir.)], a federal circuit court of appeals held that stock market operations did not constitute a trade or business even if they were continuous, regular, and extensive. The Mollers worked a 40-hour week at their investment activities but were basically long-term holders in their investments. Finally, in Purvis [37 AFTR2d 76-968, 530 F2d 1332 (1976, CA-9)], the Ninth Circuit Court of Appeals upheld a prior tax court decision [Purvis, TC Memo 1974-164 (1974)] and agreed with the Tax Court that in order to be classified as trading, the activity should be performed with sufficient frequency to “catch the swings in the daily market movements and profit thereby on a short-term basis.”
Given these and other decisions, the federal tax court has developed a two-part test that must be met for a taxpayer to be classified as a trader. [Frederick Mayer, TC Memo 1994-209 (1994)]This test creates a two-pronged definition that fits some day traders but not all online traders: The trading activity must be substantial (daily or almost daily) and must seek to catch the swings in daily market movements and to profit from these short-term swings (versus, for example, one that seeks to profit from the long-term holding of investments).
As of 1997 [when section 1001(b) of P.L. 105-34 added section 475(f) to the IRC], there are three possible classifications for online traders or day traders: investors, traders, and traders subject to the mark-to-market accounting rules of IRC section 475(f).
According to section 475(f)(3), a trader can elect the mark-to-market accounting rules without IRS consent. However, once made, the election applies to all subsequent taxable years in which the taxpayer obtains IRS permission to revoke the election. The tax treatment for each type of taxpayer is shown in Exhibit 1.
Gains and losses. For investors and traders (as opposed to mark-to-market traders) the results are the same except that gains and losses realized (i.e., when a sale of the security has taken place) are subject to recognition for tax purposes. Section 1222 describes the netting process that is followed, and the result is capital gain or loss (net long-term, net short-term, or both).
Under section 1(h), net long-term capital gains are taxed at lower rates. Generally, the rate on long-term capital gains is 20%. Long-term capital gains that would be subject to a regular tax rate of 15% if they were ordinary income are subject to a lower capital gain rate of 10%. On the other hand, short-term capital gains (i.e., those most likely experienced by traders) receive no special tax-rate treatment and are taxed at the same rate as ordinary income.
For traders and investors, section 1221(b) provides for using capital losses (long-term and short-term) on a limited basis to offset ordinary income (e.g., from salaries, businesses, interest, dividends). However, this use of a net capital loss is limited to $3,000 per year. A trader or investor suffering a large net capital loss in a given year can carry over the amount exceeding $3,000 to future tax years. If the capital loss carryover is a significant amount, using the loss to offset ordinary income can take a number of years. This passage of time diminishes the present value of the future tax savings associated with a large capital loss carryover of this type. However, there is no limit on the amount of capital loss carryover a taxpayer can use to offset capital gains in future years.
The tax treatment for mark-to-market traders is quite different. First, section 475(f)(1)(B) requires segregating securities that constitute trade or business (trader) activity from those that are more long-term in nature. Securities related to the taxpayer’s trading activity are considered to constitute an inventory of securities. At the end of the tax year, all securities are marked-to-market and the gain or loss is calculated based on a security’s fair market value at year end. Added to this is any realized gain or loss resulting from the sale of securities out of this inventory during the tax year. The resulting gain or loss is ordinary income, per sections 475(f)(1)(D) and 475(d)(3).
The mark-to-market rules produce advantageous tax results for the electing trader. If a mark-to-market trader suffers a net capital loss in a given tax year, there is no limit on the amount of currently deductible loss, because the mark-to-market trader has ordinary (not capital) loss not subject to the $3,000 loss limitation rules of section 1211(b). Any net gain by a mark-to-market trader is treated as ordinary income. Even though this ordinary income is subject to regular tax rates, the tax result is no worse than it would be without the mark-to-market election. (Remember that because the taxpayer’s activity must be short-term in nature, any gains would be short-term and, if classified as capital, subject to the same tax rates as ordinary income.)
However, the IRS may scrutinize large losses, and the “not-for-profit activity” rules of section 183 constitute one tool the IRS could use to challenge such deductions.
Wash-sale rules. The wash-sale rules of section 1091 generally prevent deducting losses from the sale of securities if, within a 61-day window around the sale (from 30 days before to 30 days after), the taxpayer has purchased similar securities. Online or day traders trying to take advantage of market fluctuations to dart into and out of a given security will find that the wash-sale rules do not apply to mark-to-market traders, per section 475(f)(1)(D).
Self-employment income. The gain or loss generated from stock transactions is not subject to the self-employment tax. This is also true for mark-to-market traders per section 475(f)(1)(D), even though their gain or loss constitutes ordinary income.
Trading-related expenses: general. Stock traders encounter a number of investment-related expenses. Typical examples include the costs of subscriptions to investment-related newspapers and periodicals such as the Wall Street Journal and Barron’s, fees paid to investment advisory services, and costs associated with the software and hardware used in online trading. When used in a business-related activity, software is generally amortizable over three years, per section 167(f)(1).
The write-off of hardware costs is more complex. Computer hardware can be classified as “listed property” as defined in section 280F(d)(4)(A). If computer hardware is classified as listed property, then at least 50% of its usage must be classified as trade or business activity in order for the taxpayer to use the modified accelerated cost recovery system (MACRS) of section 168 to write off the computer hardware costs. If this 50% threshold is not met, then section 280F(b)(1) requires that any allowable depreciation expense must be calculated using the alternative depreciation system (ADS) of section 168(g). Therefore, the taxpayer must use straight-line depreciation (ADS) as opposed to the accelerated depreciation approach allowed under MACRS. Because investors involved in online trading are involved in a production-of-income type of activity (as opposed to a trade or business activity), investors must use ADS to calculate the allowable depreciation on computer hardware. Traders and mark-to-market traders using 50% or more of the computer’s time for their trading activity can use MACRS.
Section 280F(d)(4)(B) provides that computer hardware will not be treated as listed property if it is used exclusively at a regular business establishment and is owned by the owner or operator of that establishment. A regular business establishment can include the portion of a personal residence that meets the “exclusive use” requirement of section 280A(c)(1). Assuming that the use of a particular computer qualifies for this exception (i.e., it is not classified as listed property), any allowable depreciation can be calculated using the MACRS rules. Only traders or mark-to-market traders would be eligible to treat computer hardware costs as “nonlisted property.”
An alternative approach to writing off costs of computer hardware eligible for MACRS depreciation would be to expense these costs (up to $20,000 in 2000) by making a section 179 election. Because investors cannot use MACRS, they are also ineligible for the section 179 election for hardware costs. Traders and mark-to-market traders can make this election only if they are eligible to use MACRS.
Because section 179(d)(1) requires property eligible for the expensing election to be depreciable using the MACRS rules of section 168, no section 179 election can be made regarding software costs, which generally must be written off using the three-year period required by section 167(f)(1). However, if software costs are bundled with computer hardware costs, the entire bundled cost may be eligible for MACRS treatment if the other requirements are met, in which case the entire bundled cost would be eligible for the section 179 election. For software replaced annually (e.g., tax preparation programs), the total costs can be expensed.
Investors must deduct all of the above expenses as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor required by section 67(a). Expenses greater than 2% of AGI may still be eliminated for higher income taxpayers by the itemized deduction phase-out rules of section 68. However, traders and mark-to-market traders can deduct these expenses from AGI without limitation on Schedule C of Form 1040.
Trading-related expenses: investment interest. Many online and day traders purchase securities on margin, h in essence a loan from a broker that allows the trader to leverage the investment. Brokers charge interest for these loans, and investors must treat margin interest expense as investment interest expense. Per section 163(d), this expense is deductible in the current year only to the extent of net investment income.
Traders and mark-to-market traders, however, can deduct the full amount of this interest expense in the current year because it is related to their trade or business.
Home office deduction. The congressional history of section 280A clearly requires that an activity be related to a trade or business in order for certain home office related expenses to be deductible (e.g., maintenance, repairs, utilities, insurance, depreciation).
Production-of-income types of activity will not generate a home office deduction. Therefore, investors are not qualified to take a deduction for the expenses listed above if they are associated with a home office. Only traders or mark-to-market traders can be eligible to deduct these types of expenses. Even then, they must meet the “exclusivity requirement” and the “business use” requirement of section 280A(c)(1), which requires that a portion of a dwelling unit (personal residence) be used exclusively as the principal place of business for any trade or business of the taxpayer. Even if this requirement is met, the expenses would be subject to the gross income and ordering requirements of section 280A(c)(5), restricting the expenses deductible in the current tax year to the extent of the gross income generated by the home-office business. If this limitation prevents all qualified expenses from being deducted in the current year, then these expenses must be deducted in the following order:
Again, if a portion of the dwelling unit constitutes a qualified home office per section 280A(c), any computer used exclusively in that portion of the dwelling would not be classified as listed property. Therefore, traders or mark-to-market traders can use the section 179 expense election or MACRS regarding this computer hardware cost.
Assume the facts for a particular day trader as shown in Exhibit 2. To focus the example on basic issues, the assumption is made that these costs are the same for all taxpayer classifications.
The tax treatment of the hypothetical day trader depends on whether she is classified as an investor, trader, or mark-to-market trader for the tax year (See Exhibit 3).
If the day trader (taxpayer) is treated as an investor, the recognizable short-term capital loss will be $13,000 ($53,000 loss minus $40,000 gain). The $7,000 loss related to the wash-sale transaction will be disallowed because the wash-sale rules apply). Of this $13,000 short-term capital loss, $3,000 can be deducted in the current tax year on Schedule D and will ultimately offset other forms of income (e.g., interest income and salary income). The taxpayer can carry over the remainder of the short-term capital loss indefinitely to future tax years.
The taxpayer’s home-office expense is not deductible because it is related to a production-of-income type of activity; neither is the taxpayer’s margin-interest expense deductible (presuming that there is no net investment income).
Finally, the related expenses of $4,000 can be listed on Schedule A as miscellaneous itemized deductions to the extent that these deductions, in the aggregate, exceed 2% of AGI. Even then, tax benefits will be limited or eliminated if either of two situations exist:
If the taxpayer is a trader but does not elect the mark-to-market rules, the results are the same as for an investor, with three exceptions:
The tax treatment of a mark-to-market trader is quite different from that of an investor. The wash-sale rules do not apply; therefore, the net loss is $20,000 (the entire $60,000 loss offset by the $40,000 gain). Second, this net $20,000 loss is ordinary and, therefore, fully deductible on Schedule C. Again, the IRS will scrutinize this approach, and the taxpayer must clear several hurdles including qualifying as a trader, properly making the section 475(f) election, and complying with sections 183 and 469.
The mark-to-market trader has several of the same advantages that the nonelecting trader has over the investor: The $4,000 of related expenses are deductible for AGI on Schedule C, and the margin interest expense of $10,000 is not considered to be investment interest expense subject to the limitations of section 163(d). Instead, it constitutes interest expense related to the taxpayer’s trade or business; therefore, it is fully deductible in the tax year it is incurred or paid. While the home-office expense is eligible for deduction if it meets the exclusive use test, it cannot be deducted under the scenario given in the example because the activity did not generate income.
Additionally, neither gains nor losses generated by investors, traders, or mark-to-market traders are treated as self-employment income or loss. Therefore, the self-employment tax of section 1401 does not apply. Likewise, there is no deduction for one-half of the self-employment tax under section 164(f).
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