I looked into declaring trader status a few years back and actually read the tax court cases. A lot of folks think it sounds like a great thing to do and get really excited about it.
When it comes to the financial markets, the IRS considers each taxpayer to be an investor as opposed to a trader for tax purposes. This means that you pay capital gains taxes on any profits and that you have limited ability to deduct losses. Some people make trading their livelihood as opposed to a method of investment. If this describes you, then you might quality for trader tax status.
The primary benefit of being a "trader in securities" is that you get to treat your trading activity as a business. This means that you can take a deduction for money you spend on things like trading seminars, trading software, data feeds, trading books, etc. They are simply considered reasonable business expenses.
Any profits you earn are not considered profits but are considered income. This means you treat profits as ordinary income, deduct your reasonable business expenses from that income, and pay income tax on the difference. Unlike an investor, if you take a loss for the year it is considered a business loss and you can deduct it against other ordinary income; e.g., income from your day job.
Here's the rub. If you have a day job you probably do not qualify as a trader in securities. The tax court cases that I read provide no clear line of demarcation between those who satisfy the IRS requirements for being a trader in securities versus being an investor. My reading suggests to me that the IRS and the tax courts are very skeptical about retail traders and look very closely at your day-to-day activity.
If you're putting on an iron condor each month, maybe trading a few calendars or some covered calls you probably will not pass muster. They want to see substantial trading activity on a daily basis throughout the year. They want to see you treating trading like a business. My guess is that anyone who files an election to be treated as a trader in securities triggers a red flag with the IRS, especially if you are also showing W2 income on your returns.
Here's another thing to consider. The hobby loss rule can also come into play if you are not generating profits from your trading. If you are losing money one year to the next the IRS may challenge the deductions under the hobby loss rule, arguing that you do not have a reasonable expectation of profit and are engaged in a hobby. They will look for things like whether you have written trading plans or whether you're routinely changing from one strategy to the next on apparent whims.
My conclusion was that for most people trading options at a retail level the trader in securities election is going to be more trouble than it is worth. For the small group of us that develop the skill, acquire the capital base, and choose to make trading our full time profession it may then make sense to pursue the election. Even then I would encourage anyone to seek competent advise from a reliable tax lawyer or CPA firm that has experience in this area.
Christopher Smith
TheOptionClub.
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