There are three different IRS definitions that you need to know if you’re involved with stock investing. These are: stock trader, stock investor and mark-to-market. The difference between these will make a big difference in your taxes.
Traders vs Investors
Traders engage in frequent buying and selling and usually own securities very briefly, for a few days or even a few minutes. They trade continuously over the whole year. The strategy is to make money on short-term swings.
An investor earns profits mainly on long-term appreciation and dividends. They hold for a longer period of time and aren’t nearly as active as traders in the stock market.
For tax purposes, an investor will earn profits with long-term appreciation (capital gains) and through dividends. Currently the long-term rates are 0%, 15% or 20%, depending on the taxpayer’s income level. They may also be subject to the 3.8% Medicare surtax. It kicks in at $200,000 for modified adjusted gross income or $250,000 for married, filing jointly filers. Losses are capped at just $3,000 over capital gains per year. The excess losses can be rolled forward and used against future gains. Investors can’t deduct any expenses on Schedule C.
A trader CAN deduct their expenses on Schedule C. Their gains will be taxed as ordinary income. However, the profits are not subject to self-employment tax. Losses will also be capped at $3,000 over capital gains per year.
Traders and Mark-to-Market Election
A trader’s losses are considered capital losses and while they can be used to fully offset capital gains, their losses to be applied against other income are capped at $3,000. A big loss could mean you’re waiting years until you can deduct all of it.
There is a solution for traders though. The way to fully deduct losses is by making a Section 475(f) election. This is commonly known as the “mark-to-market” election. It’s not a matter of just making an election and then suddenly you get to take all of your losses. There is a little bit more to it.
Traders who make this election recognize gains and losses as if they’d sold their holding for FMV (fair market value) on the last day of the tax year. The gains and losses are treated as ordinary income and loss. The election MUST be done by 4/15 of the next year. Once made, the election continues for each year unless revoked under special rules. The deadline to make an election for the 2021 tax year is April 15, 2021. If you want to elect and haven’t done so previously, you must attach a statement to your 2020 Form 1040, or with your timely request for a filing extension.
Investor, Trader, Mark-to-Market
The Investor vs Trader definition isn’t something you decide. It’s determined by the way you approach your investments. The Mark-to-Market election is an election that the Trader can make. You control that.
Which is best? It depends on your circumstances. This is when you need to have someone who understands the law and your personal goals and situation. A consultation may be the best the route for you. Just make sure you don’t wait too long. The window is closing rapidly for making the proper election. Contact us for more information on a consultation.