Death and taxes.
The only two certainties in life.
Trying to understand thousands of pages of the tax code can be a daunting tax.
As traders, we are constantly bombarded with irregular forms of income. Deciphering this income in your tax documents can be complicated and often confusing.
To make sure you don’t dread tax time, you are going to learn common terms to help you navigate through the requirements, if you should declare that you are a trader or investor, if you should trade as a company, what are wash sales, and how you can trade for a better tax advantage.
But first, we are traders, not a tax specialist. It is always best to consult your accountant, CPA, or financial advisor before making decisions concerning your taxes.
What You Need To Know For Taxes
There are a few terms you should know before progressing.
The amount of money you originally paid for a security plus commissions is cost basis. Cost basis will be used to determine the overall price for a position and to establish your gains and losses.
If you were to open 100 shares of The Option Prophet (sym: TOP) for $45 a share, plus a commission of $4.95, your cost basis would be $45.05.
(Shares x Stock Price + Commissions) / Shares
(100 x 45 + 4.95) / 100
4,504.95 / 100 = $45.05
Cost basis is typically expressed as a per share, as described above, but it can also be described as a total.
Shares x Stock Price + Commission
100 x 45 + 4.95 = $4,504.95
Knowing your cost basis for taxes is important, but it is also important to know for your trades. Your cost basis will adjust if you receive dividends, a stock split, or if you purchase more of the underlying. By knowing your cost basis, you will also know if you are profitable or not, and by how much.
Once you have your cost basis, you can calculate your capital gains and losses. Capital gains are created when you earn a profit from closing a position. You will need to keep track of your capital gains because they will be taxed.
Naturally, capital losses are created when you incur a loss when you close a position. You will want to track your capital losses because you can write them off against your gains.
During the year, you have capital gains of $10,000 and capital losses of $6,000. You would be on the hook to pay taxes against $4,000.
Capital Gains – Capital Loss = Tax Liability
10,000 – 6,000 = 4,000
Not only can you write down your current gains, but if your losses outpace your gains for the year, you can write off an additional $3,000 and carry $3,000 in losses forward to next year.
If you have $10,000 in capital losses and $5,000 in capital gains this year your tax liability would be $-3,000.
You can use the $10,000 in losses to offset the $5,000 in gains. This will leave you with $5,000 in losses. You can take an additional $3,000 to lower your tax liability to $-3,000 for the year. This will leave you with $2,000 in losses to carry forward to the next year.
Next year you have $3,000 in capital gains and no capital losses. You can carry the $2,000 from the previous year forward and lower your tax liability.
Capital Gains – Capital Losses = Tax Liability
$3,000 – $2,000 = $1,000
Even though you are taking some losses, it is good to know you can use them to your advantage.
What Are Short-Term Capital Gains
If you do not hold a position for more than one-year, 365 days, you will generate short-term capital gains. As an options trader, most of your trades will be short-term trades. Only if you trade LEAPS will you hold one position for more than a year.
The bad news, short-term capital gains receive unfair tax treatment. Your profits will be taxed at your ordinary income rate, which can be quite high.
What Are Long-Term Capital Gains
If short-term capital gains happen when you sell a position under one-year, then long-term capital gains occur when you hold a position more than one-year. This is one of the perks of buy and hold investing. If you own a position for more than one-year, you will get favorable tax treatment. Long-term capital gains are usually taxed at around 15% or lower. This can be a significant advantage and money-saver versus short-term gains.
Options And Wash Sales
A wash sale is when a position is sold at a loss and then repurchased within 30-days. The IRS won’t let you take the loss at that time. The loss is deferred until you close the new position. This is to prevent you from taking losses in positions to lower your tax rate and then quickly buying back the same position.
The IRS goes even further to state the new position can’t be substantially the same as the original position. This note can have an adverse effect for options traders.
A “substantially the same” option position is any option position on the same underlying, no matter the expiration month or strike price.
Not only does the IRS not want you to trade options on the same underlying but if you sell a stock at a loss and then buy an option on that stock, it could count as a wash sale.
If you incur a wash sale, it isn’t the end of the world. In fact, very little will happen in most cases. If left unchecked, you could be in for a surprise at the end of the year. What you thought was a losing year, could end up being a winning year, tax-wise. Or, what you thought was a lower tax liability could end up being a lot larger than expected.
Are You A Trader Or Investor
Deciding if you are a trader or investor may be a simple determination in your mind. Investors typically hold stocks for an extended period, and traders want to take advantage of the daily movements in the markets.
Unfortunately, the simple distinction ends there.
The IRS defines a trader as, “A taxpayer’s activities constitute a trade or business where both of the following requirements are met: (1) the taxpayer’s trading is substantial, and (2) the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments”.
If we look at each one of those requirements separately, we can understand what the IRS considers a trader.
First, the taxpayer’s trading is substantial. Per past court cases, the IRS wants you to trade at least 500 trades in a year. That means you are making at least two trades a day, every day.
Not only are you making enough trades but the IRS wants to know you are trading enough size. There hasn’t been a clear case to establish a baseline regarding money, but we can assume that this is supposed to be large enough to live off. The idea if you are a “trader” is that this is your full-time job and the amount of money traded should represent that.
If you meet that requirement, the second one should be easier for you.
Second, the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to benefit from the long-term holding of investments.
The IRS wants to make sure you trade most of the 252 trading days available. They see this as your full-time job and want you to show proof. It doesn’t matter if you make enough trades to cover the minimum if you only trade 150 days of the year.
If you are lucky enough to get the “trader” designation, then you have a few rewards coming to you.
The best of which is the fact that you can now deduct all your trading-related expenses. Investors, on the other hand, can only write-off a small portion of their trade-related expenses. Computers, desk, bookshelves, printers, and a home office are just a few of the deductions you can now take. You will also keep the same capital loss rules.
Unfortunately, most traders will not qualify for the trader status the IRS has put in place. It is not the end of the world; there are other ways to receive these deductions.
Should You Start A Trading Company
One of the big questions among traders is if they should start a company to trade under. There are both benefits and negatives to trading under a company as opposed to trading as yourself.
Typically, you would want to start an LLC. Limited liability companies can be formed by one person or several, have low startup fees, and can still benefit from pass-through taxation. Every state has different rules for forming an LLC, but most require light paperwork and a one-time fee.
As a company, you can now deduct all trading related expenses. This is a great way to benefit from the “trader” status set by the IRS without having to meet their requirements. The IRS believes that if a person goes through the trouble of creating a company they must be a real trader.
The most significant benefits of using a company will be the tax deductions and the ability to trade with multiple investors, such as family or an investment club.
Unfortunately, the IRS is not the only one who will think you are a professional trader. All option brokerages label a trading company as a professional. Besides the fancy title, you will now be hit with extra fees.
The real-time data that you received for free before will now come at a price. Typically, brokerages charge several hundred dollars a month for real-time data. Not only do brokerages label you as a professional but the software you use for analysis will also want to know if you are a professional.
Before making the jump to an LLC or other entity, it is best to check with your brokerage and service providers on their treatment of “professionals.” Often, the services you’ve enjoyed for free will now come with a hefty price tag.
The Benefits Of Section 1256 Contracts
One of the very obscure trading tax rules is the treatment of Section 1256 Contracts. A Section 1256 Contract includes all future trades, options on futures, and options on cash-based indices, such as Russell 2000, S&P 500, and VIX.
What does this mean for you and why do you care?
When you trade a Section 1256 Contract, no matter how long you hold the position, it will be treated as 60% long-term and 40% short-term capital gains.
It doesn’t matter if you hold the position for 1-minute, 1-day, or 1-year. This is great news for traders of options on the S&P 500 because it lowers your taxes on gains.
If you made a $100 profit trading a call option on the S&P 500, $60 would be taxed at 15%, and $40 will be taxed at your income level.
Options on exchange-traded funds such as SPY, IWM, or DIA do not qualify as Section 1256 Contracts. When trying to debate between trading the SPX or SPY, you can now consider the SPX for tax purposes.
Trying to decide how to tackle your taxes can be a challenging task. There seem to be an infinite amount of moving parts and the IRS does not go out of their way to make it easier on you.
While the majority of your taxes should be handled by a professional, there are things you can do in your trading to give yourself an advantage.
It is rare for traders to be able to elect for the “trader” status but you can achieve the same benefits by starting a company and trading from that.
Options on the S&P 500 and other futures contracts benefit from being Section 1256 Contracts. Trading these will give you significant tax benefits as 60% of the gains will be taxed at the lower long-term capital gain rate.
Nobody likes to pay extra taxes, but it does mean you are making money with your trades.
What are your tax tips? Tell us in the comments...