First of all, you must know to differentiate between an investor and a trader. Generally, a trader seeks active gains by buying and selling stocks, termed as day traders. An investor, on the other hand, holds the securities and investments for longer-term. The investors play the long game, traders play the shorter one.
A common mistake is to claim more losses as an investor than allowed. Active traders can deduct excessive losses, but they need to qualify as a trader rather than investors.
The IRS sets different rules for investors and traders. Professional entities and dealers also file their tax returns separately, as they proceed with customers’ investments that may incur losses or gains.
When do you qualify as a Trader?
Individuals who actively perform trading can qualify as traders. They are exempted from the self-employed taxes, and also enjoy better tax relief than investors. Traders report their trading income and losses on Schedule C where they can fully deduct all trading expenses too. These expenses must directly relate to the trading activities though.
The IRS will categorize you as a trader if:
You actively take part in trading activities, i.e. your trading must be substantial
Your trading activities must continue regularly and consistently
You are involved in trading for making profits i.e. it can be termed as your earning activity
Additionally, the IRS analyzes the magnitude of your trading activities. You must pursuit the trading activities as a business, otherwise, you will be categorized as an investor. The trading amount invested in stocks and securities will also play an important role in determining whether you seek the activity as business or not.
What is the Mark-to-Market Election rule for Traders?
Significant relief for active traders comes from this Mark-to-market rule. If you elect the accounting practice, section 475(f) allows you to treat all securities and stocks held under this practice on the last day of the tax year.
Under this rule, all of your active trades on the last business day will be considered closed on paper. That simply means, you can convert your gains and losses on paper, even though your trading positions may still be open practically.
The Mark-to-market rule benefits traders with:
Closing trades as all securities are listed sold on paper on the last business day of the year
The gains and losses arising from the trading activities can be treated as normal income/losses rather than capital gains or losses
No upper cap of $3,000 on losses as with investors
Active trading incurs more losses than investing. Day trading is a high risk, that’s why it is more lucrative too, as it also yields more gains to some traders.
How Do You Qualify As an Investor?
Investors hold capital assets. Capital assets include investments in stocks, securities, houses, cars and other long-term assets. Any gains or losses arising from these activities must be reported on Schedule D (Form 1040 or 1040-SR).
Important points to consider:
The limit on losses with capital assets is $1,500 for a single filer and $3,000 for joint filers.
Both long-term and short-term gains must be reported from capital assets or investments.
Any net gains from investments or the sale of capital assets must be reported.
The losses on investment and other capital assets can be deducted but not the personally used properties.
What If You Have Invested In Cryptos?
Trading in virtual currencies commonly called cryptocurrencies is on the rise. These cryptocurrencies like Bitcoin are highly volatile. Traders make swinging gains and losses with virtual currency transactions. Many tax filers try to offset losses with virtual currency trading losses as day traders. This can lead you to an IRS audit if you fail to report any gains on investment/trading with virtual currencies.
Unfortunately for virtual currency traders, the IRS declares these digital assets just like other “property and assets”. IRS applies general tax principles with these transactions and you’ll need to report capital gains and losses on Form 8949 as sales and disposition of assets.
One common misconception with gains or losses with digital currency trading is to wait until it converts to real currency. Even if you experience another gain or loss at the time of conversion to real currency, you’ll need to report it. Any other ordinary income from digital currencies must be reported on Form 1040, 1040-SS or 1040-Schedule 1.
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