How trader status may reduce your income tax.
What’s the big deal about being a trader? How do you end up being treated better than an investor? Here’s a rundown on major tax benefits of trader status:
Investors can claim interest expense only if they itemize, and only to the extent permitted under the investment interest limitation. Traders deduct their interest expense on Schedule C, so they don’t have to itemize and the investment interest limitation doesn’t apply.
Investors aren’t permitted to claim a deduction for the cost of investment seminars. If a trader attends a seminar to improve his ability to trade, the cost may be deductible.
Home office deductions are not allowed in connection with investing. A trader may be able to claim a home office deduction.
Various other expenses of an investor, such as the cost of books and subscriptions, are “miscellaneous deductions.” These deductions are not allowed for the years 2018 through 2025, and even when allowed are of value only if the investor itemizes, and only to the extent the total miscellaneous deductions exceed 2% of adjusted gross income. A trader deducts these items on Schedule C.
Being a trader makes you eligible for mark-to-market accounting — but only if you make the mark-to-market election. If you qualify as a trader and you make this election, the following additional benefits are available:
- The wash sale rule won’t apply to your trading activity.
- If you have an overall loss for the year, your loss deduction won’t be subject to the $3,000 capital loss limitation.
The biggest disadvantage of filing as a trader is audit risk. There are no clear standards for determining whether you are a trader. If you claim to be a trader, and the IRS determines that you are not a trader, you may end up with substantial liability for tax, interest and penalties.
If you make the mark-to-market election, you have two other potential disadvantages to deal with:
- Your trading profits are ordinary income, not capital gains.
- At the end of the year you have to report all your profits, including profits from unsold stocks.
There’s another disadvantage of filing as a trader: relatively few tax professionals are familiar with the rules. You may have difficulty finding someone who can provide competent help with your tax return.
Because of uncertainty about the definition of trader, and the potential for inviting an IRS audit, I counsel against filing as a trader unless both of the following are true:
- You have enough at stake so that the tax benefit outweighs the hassle of going through an audit, and
- You have at least a reasonably strong claim to trader status by reason of an extended period of extensive short-term trading.