By: Ara Oghoorian, CFA, CFP, CPA
Updated: November 24, 2023
If you trade a substantial amount of securities on a regular basis, you may qualify for Trader Tax Status (TTS) and be able to deduct expenses related to your trading business, offset your W-2 income, deduct losses greater than the current $3,000 annual limit against your income, and avoid wash-sale rules.
While Trader Tax Status sounds very appealing, you must meet very strict guidelines to qualify. More details can be found in IRS Topic 429. It’s important to note that these rules are applicable only to taxable accounts, and tax-deferred or tax-free accounts do not qualify.
The IRS classifies traders in securities into three (3) categories: Investors, Dealers, and Traders. In addition, Traders may choose to make a Mark-to-Market election on their tax returns to garner even greater benefits.
Investors
Investors are individuals who trade securities with the goal of earning interest, dividends, and/or capital appreciation. This is the typical person who occasionally buys and sells securities in their personal portfolio.
Investors are not engaged in a trade or business when they trade securities, they are simplifying buy/selling securities for personal investment. As a result, investors are not allowed to deduct investment related expenses against their investment related income.
Investors must report their annual realized gains and losses on Schedule D and Form 8949 on their 1040. Form 8949 shows the details of each transaction while Schedule D shows the summary separated by short-term and long-term gains/losses.
Investors cannot deduct more than $3,000 of losses per year and are subject to wash sale rules which take many traders by surprise. In addition, Investors are not allowed to deduct trading related costs as business expenses.
Dealers
Dealers are individuals or business entities engaged in the trade of securities.
Dealers routinely engage in the buying and selling of securities with their clients as part of their regular business operations. In some instances, dealers maintain an inventory of securities.
The key distinction between dealers, investors, and traders lies in the fact that dealers have clientele and earn income by marketing securities to clients or by receiving compensation for intermediary or market-making services.
Traders (Trader Tax Status)
A trader is someone who is in the business of buying and selling securities for their own account and qualifies for Trader Tax Status. Trader Tax Status allows you to treat your trading activity as a business which allows you to take deductions against your income. If you are an investor, you are not considered to be in business and therefore cannot take any business deductions. The IRS classifies trading activities as a business even if the trader does not maintain inventory. As a result, traders are subject to special benefits that don’t apply to investors.
What are the Benefits of Trader Tax Status (TTS)?
-
- Your trading income is not subject to self-employment tax because the income is not reported on Schedule C.
- You are allowed to deduct business expenses against your trading and W-2 income (see below for a list of eligible business expenses). So even if you have a trading loss, you can deduct your trading expenses against your W-2 wages.
- You can separate which investments are held for trading and which are held as investment.
- You can make a Section 475(f) election and report trading activity under “mark-to-market” rules which do not subject you to wash sale rules or the $3,000 annual loss limitation.
- You may be eligible for the SALT limitation workaround such as the elective Pass-Through Entity (PTE).
Drawbacks to Trader Status
- It is difficult to qualify as Trader Tax Status because strict conditions must be met.
- Gains from trading are taxed at the higher short-term capital gains tax rate since positions are held less than a year.
- $3,000 capital loss limitations still apply, unless you make a Section 475(f) election.
- Wash sale rules still apply, unless you make a Section 475(f) election.
- Only eligible for taxable accounts. Retirement accounts do not qualify for Trader Tax Status (TTS).
How to Qualify as Trader Tax Status (TTS)
According to the IRS, you must meet all of the following conditions to qualify as Trader Tax Status:
- 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.
In addition, the following facts and circumstances should be considered to determine if you are in the business of trading:
- Typical holding periods for securities bought and sold;
- The frequency and dollar amount of your trades during the year;
- The extent to which you pursue the activity to produce income for a livelihood; and
- The amount of time you devote to the activity.
The Mark-to-Market Election
Once you qualify for Trader Tax Status, you are eligible to make a mark-to-market election under Section 475(f). Only traders can make this election, Investors are not eligible. The mark-to-market election will allow you to treat your gains and losses from the sale of securities as ordinary income or loss instead of capital gains/losses. Ordinary losses can offset your ordinary income (i.e. wages) and are not restricted by the annual $3,000 limitation imposed on Investors. In addition, the wash-sale rules do not apply to traders who make a mark-to-market election.
Benefits of Making a Section 475(f) election
- Losses can offset ordinary income such as W-2 wages, interest, dividends.
- Income not subject to self-employment taxes.
- The $3,000 capital loss limitations do not apply.
- Wash sale rules do not apply.
- Eligible for Qualified Business Income (QBI) deduction as Specified Service Trade or Business (SSTB) because you are involved in a trade or business.
- You may be eligible for the SALT limitation workaround such as the elective Pass-Through Entity (PTE).
How to Make a Mark-to-Market Election Under Section 475(f)
To make the mark-to-market election under Section 475(f), you must attach a statement either to your timely filed tax return (not including extensions) or to your request for extension Form 4868. You must also file Form 3115 – Application for Change in Accounting Method. Keep a copy of your statement and proof that it was filed timely.
The statement must include the following information:
- That you’re making an election under section 475(f)
- The first tax year for which the election is effective (that is, the tax year for which a timely election is being made); and
- The trade or business for which you’re making the election.
William F. Poppe vs. Commissioner of the Internal Revenue Service
Poppe vs. IRS is a highly referenced case for traders seeking TTS and mark-to-market status. In that case, Poppe won the TTS status eligibility, but lost the Section 475(f) election. Therefore, if you’re planning on claiming TTS, make sure to do the minimum things that earned Poppe TTS and not make the same mistake as Poppe to lose the Section 475(f) election.
- His activity was considered substantial because he placed 60 trades per month (720 trades per year).
- It’s not enough to call yourself a day trader. You must trade regularly and continuously. Placing a large amount of trades a few times a year will not qualify. It must be consistent. Poppe spent 4-5 hours per day trading and consistently traded on the last hour of the day when market volume was highest.
- His intent for trading was short-term profits from price moves. He did not buy securities to earn interest or dividends.
- While Poppe qualified for TTS and was able to deduct his business expenses, he did not qualify for the more lucrative Mark-to-Market status because he did not make a timely Section 475(f) election nor did he file Form 3115.
- It’s not enough to make a timely Section 475(f) election, you must also perfect the election by filing Form 3115. Poppe could not prove that he made a Section 475(f) election because he did not keep a signed copy for his records or proof of mailing the form.
- Remember that you must first qualify for TTS before you can make a timely Section 475(f) election.
What is the Pattern Day Trader (PDT) rule
Beware of the Pattern Day Trader (PDT) rule if your account balance is less than $25,000. Per FINRA, if you place four or more roundtrip trades within 5 business days and those trades equate to more than 6% of your account activity, you will be classified as a Pattern Day Trader by your broker and prevented from placing additional trades. A roundtrip trade is when you open (buy) and close (sell) a position. If you are flagged as a PDT by your broker, they may prevent you from trading in any new positions or require you to deposit more cash.
So if you’re planning on qualifying for Trader Tax Status, be sure to have at least $25,000 of equity in your account so that your trading capacity is not limited; otherwise it will be much more difficult to qualify as a Trader. Equity can be maintained by either cash or marketable securities.
Tax Reporting for Investors and Traders
Tax reporting for Investors and Traders depends on whether or not you qualify for Trader Tax Status and if you have made proper a Section 475(f) election.
Tax Reporting for Investors
- Gains and losses are reported on Schedule D and Form 8949.
- Trading expenses are not deductible and therefore not reported.
- Capital losses are limited to $3,000 per year and wash-sale rules apply.
Tax reporting for traders who qualify for Trader Tax Status, but have not made a Section 475(f) election
- Gains and losses are reported on Schedule D and Form 8949.
- Trading expenses are deductible and reported on Schedule C.
- Capital losses are limited to $3,000 per year and wash-sale rules apply.
Tax reporting for traders who make a proper Section 475(f) Mark-to-Market election.
- Gains and losses are reported on Form 4797 – Sales of Business Property.
- Trading expenses are deductible and reported on Schedule C.
- Losses will offset ordinary W-2 wage income on the first page of 1040.
- Wash sale rules will not apply.
Frequently Asked Questions Regarding Trader Tax Status
What expenses are deductible for a trader under Trader Tax Status?
Traders are allowed to deduct the following business expenses depending on your entity type:
- Interest (margin) expense
- Computer and technology
- Travel to/from conferences
- Subscriptions
- Investment research costs
- Education
- Office supplies
- Home office
- Depreciation, including bonus and Section 179 depreciation
- Employee benefits (i.e. retirement and health insurance)
- Accounting fees
- Pass-Through Entity tax, if you’re a corporation
Is a Day Trader Subject to Self-Employment Taxes?
If trading is considered a business, the question then becomes is trading income subject to self-employment taxes? The answer is no. One of the biggest benefits of a Trader Tax Status is the fact that income earned from trading is not subject to self employment taxes.
How often do I have to trade to qualify for trader tax status?
You must trade frequently and regularly to qualify for trader tax status. While the IRS does not define frequently and regularly, in the highly referenced case Poppe vs. Commissioner, the taxpayer Poppe was granted trader tax status for trading 4-5 hours per day and making 60 trades per month.
Do traders file Schedule D or 4797?
It depends. Investors and Traders report gains and losses on Schedule D and Form 8949. Traders who make a valid mark-to-market election under Section 475(f) report their gains and losses on Schedule 4797. The difference is that Investors and Traders are subject to the annual $3,000 cap on losses whereas Traders who make a valid mark-to-market election and file Schedule 4797 are not subject to the $3,000 annual loss limitation.
Do wash sale rules apply to traders?
Wash sale rules apply to Investors and Traders. However, wash sale rules do not apply to Traders who make a valid mark-to-market election under Section 475(f).
Are Traders Eligible for Qualified Business Income (QBI) deduction?
Traders who have made a valid mark-to-market election under Section 475(f) are eligible for the generous 20% QBI deduction under the Tax Cuts and Jobs Act of 2017 because their trading activity rises to a Section 162 Trade or Business and their income is considered ordinary. However, trading is considered a Specific Service Trade or Business and as such has a taxable income limitation for qualify for QBI.
How do you know when you’ve been approved for TTS by the IRS?
The IRS does not approve your Trader Tax Status. If you believe that you qualify, you should report your income and expenses as a trader. The burden of proof is on you as the taxpayer to show that you qualify for TTS if you get audited.
Looking for an independent fiduciary financial advisor who can advise you on investments, retirement, real estate, alternative assets, and taxes? Contact ACap Advisors & Accountants to schedule a free initial consultation. Our clients include individuals, small businesses, entrepreneurs, and anyone serious about saving and investing for their future.
