If you buy and sell securities, you may qualify for tax status as a ‘trader,’ which importantly may qualify you for certain business tax breaks. The rules governing this status can be confusing, however, making it difficult to determine whether you qualify as a trader, investor, or dealer. Let’s take a closer look at the qualifications for traders as defined by the IRS, as well as how to report income and expenses if qualified.
The IRS defines a trader in securities by three conditions: someone who “[seeks] to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation”; they must display “substantial” trading activity; and they “must carry on the activity with continuity and regularity.” They recommend individuals unsure of their status take into account “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.”
Key to qualifying as a trader is conducting trading activities as a business pursuit, rather than doing so to hold as personal investments, or to earn income from “dividends, interest, or capital appreciation.” Traders are responsible for “[keeping] detailed records” that distinguish which holdings are a part of the trading business rather than investment holdings; securities must be identified as such from the time of acquisition.
Qualifying traders can report business expenses via IRS Form 1040, Schedule C. Commissions and other auxiliary costs relating to trading securities “aren't deductible but must be used to figure gain or loss upon disposition of the securities.” Traders are not required to pay self-employment tax on gains and losses from selling securities.
Another key distinction for traders comes from the use of mark-to-market rules. First, traders must elect to change to mark-to-market accounting via Revenue Procedure 2018-31. Doing so allows traders to make “timely mark-to-market [elections]” by “the original due date… of the tax return for the year prior to the year for which the election becomes effective,” and treat gains and losses upon selling securities “as ordinary gains and losses” using Part II of Form 4797, Sales of Business Property. They must also file Form 3115, Application for Change in Accounting Method, though failure to file this will not “invalidate a timely and valid election.” Traders who decide to no longer use mark-to-market accounting can “file an automatic request for revocation under Revenue Procedure 2018-31, Section 24.02.”
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