Financial markets have been an attractive avenue for earning money. Markets nowadays are built on complex, powerful technologies, but history has time and again proved that no technology is foolproof, at least in the markets. And with billions on the line, one cannot take any chances with security.
It is precisely because of these security concerns that the market is a quagmire of rules and regulations, and taxes form a big part of it.
To not lose your way in this thicket of provisions and statutes, we’ve come up with a crash course on taxation for day traders.
Investor, Dealer & Trader Taxes
To further delve into the particulars of taxing, one first needs to know who they are. The Internal Revenue Services and Securities and Exchange Commission acknowledge three kinds of stakeholders in the market, namely, the dealer, the investor, and the trader. They’re differentiated according to their behavior and functions in the market. The difference is crucial because they’re taxed differently.
Leaving the investor and dealer aside, let’s talk about the trader. A trader has a business interest in the market; that is, they conduct transactions not to earn specifically from dividends and interest, but from market fluctuations and volatility and trade more frequently than the average investor.
Traders are further categorized on several bases. A pattern day trader, according to the pattern day trader rule, is one who executes four or more day trades in a span of five business days. Day trades are those which are closed automatically at the end of the day. A day trader is required to have a margin account.
Self-Employment Tax & Trader Status
The self-employment tax is one of the first and foremost tax differences between a trader and an investor.
Stock market trading has become a vocation, even a lifestyle of many. Over the years, the financial markets have gained primacy and confidence, elevating themselves from the earlier status of secondary earning opportunities. But the IRS and SEC still see gains from the stock market as passive gains. In simpler terms, the money earned from business in stock markets is not seen in the same light as income, wages, and salaries, et cetera.
As a result, investors do not have to file self-employment taxes. One might rejoice at this, but in the long-run, these taxes go a long way. Self-employment taxes are contributions toward Social Security. One who files these taxes is later eligible to avail Social Security benefits. One has to earn 40 credits in total, 4 of which can be availed each year. So if investors do not have to pay self-employment taxes, they won’t earn the necessary credits to later qualify for Social Security benefits.
Moreover, operating expenses, for instance, expenditure for education, hardware, software, and so on, are not deductible for investors.
Being qualified as a trader provides succor against these tax problems. Only a small percentage of people are qualified as traders in the view of the IRS. Such traders are allowed to file a Schedule C form, in which they can avail deductions for equipment, margin interest, and other operating expenses.
Other than this, for investors, the net loss, which can be set against ordinary income, is limited to $3000. According to Topic No.409 of the IRS, “If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 21 of Schedule D (Form 1040 or 1040-SR).” This means that capital losses only up to $3000 can be carried over.
A qualified trader has the option of filing net capital position as income under Section 475 (f) by using the mark-to-market formula. As net capital positions are shown as income, they’re not bound by the $3000 rule.
Short Term & Long Term Capital Gains/Losses
For the purpose of taxation, gains and losses from stock trading are segregated into the long and short term. Short-term gains are made from selling a position within a year of buying it. Otherwise, they’re seen as long-term gains. A net capital gain, meaning an excess of net long-term gains over net short-term losses in the year, are taxed at rates generally below the usual tax rates for ordinary income.
Short-term capital gains, however, are taxed as regular income only. Long-term gains range from 0% to 20%. “Single filers with income under $38,600, joint filers under $77,200, and heads of household under $51,700 may be eligible for 0% tax on long-term capital gains.” Over and above this limit, long-term capital gains up to $479,000 for joint filers, $425,800 for single, and $452,400 for heads of households are taxed at 15%. Anything further is taxed at 20%.
Alternate Minimum Tax
To ensure that deductions and exemptions are not misused, the AMT was created. It calculates taxable income differently, using higher rates of 26% for those married but filing taxes separately up to $95,700 and 28% above that. Other than that, the rate is 26% for filers of income up to the limit of $191,500 and 28% for everything above.
Net Investment Income Tax
Investment income above a certain threshold is taxed at 3.8%. For singles, it is $200,000; for married and joint filers, $250,000; for separate filing couples, $125,000 and for heads of households $200,000.
For availing tax benefits available to day traders, it is necessary to qualify as one as per the criteria of the IRS. Traders are given the option to file their financial market gains as ordinary income to pay self-employment taxes and qualify for Social Security, and also to avail the various deductions available.
There are so many different kinds of taxes that – knowing and filing them can be, well, taxing. But one can always avail the services of a qualified accountant. Brokerage firms too offer these facilities at lower costs.