Tax advice for clients who day-trade stocks – Journal of Accountancy

The proliferation of retail trading has brought challenges as well as new opportunities for accountants. Because the tax rules surrounding day trading can be murky and complex, clients who daytrade as either a primary or secondary source of income may require the services of a tax professional. One important area in which this steadily growing group of clients may need advice is whether to make a Sec. 475 marktomarket election.

In this article, we offer some thoughts on day trading from a tax planning perspective. Practical examples are provided to illustrate the tax difference between making the Sec. 475 election versus not making the election.

THE POPULARITY OF DAY TRADING

Day trading typically refers to active trading by retail or proprietary traders who take shortterm positions in any of a broad class of financial assets, including traditional stocks, bonds, currencies (including virtual currency), commodities, futures, and, increasingly, options on these assets. Positions are typically held for as little as a few seconds (known as scalp trading) up to several days (known as swing trading). The day trader’s intent, of course, is to buy an asset for a low price and sell it at a higher price within a short time frame (in the case of a long position; a short position does the same in the opposite order).

An increasing number of online brokers provide software and platforms for day traders, who can use margin loans from the brokerage to increase their buying power to sometimes three to four times their own equity capital. With the recent advent of Robinhood, one of the first online trading platforms to allow its retail clients to place trades with $0 commissions, day trading became accessible globally to the general population. The popularity of this pursuit has driven several traditional banks and brokerages to follow suit and offer commissionfree trading to their retail clients in addition to a more expensive alternative that charges commissions for enhanced services. In making commissionfree trading available, these financial institutions see an opportunity to profit from extending margin loans to their trading clients.

In principle, day trading is like any other business in which inventory is purchased at a lower price and sold at a higher price (i.e., buy low, sell high). One difference, though, is that in the financial space, both a purchase and sale can be executed instantaneously, generating quick profits or losses. With the increased accessibility of day trading, training courses to educate anyone interested in how to trade financial assets have proliferated on the internet.

Just like with any business, trading in financial assets requires investment in equipment (e.g., hardware and software) and the payment of regular expenses including commissions, platform fees, data fees, interest on marginbased loans, and office expenses. Profit or loss from day trading has tax implications for the trader’s other incomegenerating activities.

TRADER IN SECURITIES

Typically, a day trader, because of the nature and extent of the trading activities, will for federal tax purposes qualify as a trader in securities (i.e., an individual who is in the business of buying and selling securities for his or her own account). If a day trader is considered a trader in securities, he or she can make the Sec. 475(f) marktomarket election (discussed below).

However, an individual will not be considered a trader in securities simply because the individual calls himself or herself a trader or day trader or engages in a limited amount of trading activity, regardless of its nature. To be considered a trader in securities, rather than an investor, an individual must:

  • Seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
  • Engage in substantial activity; and
  • Carry on the activity with continuity and regularity (see IRS Publication 550, Investment Income and Expenses, p. 68 (rev. March 10, 2022)).

If these requirements are not met, the individual will be considered an investor, not a trader in securities whose trading activity is treated as a business. The determination of whether an individual is a trader in securities is based on the facts and circumstances of his or her trading activity. Factors relevant in determining whether someone qualifies as a trader are discussed in IRS Topic No. 429 and summarized in the table “Distinguishing Traders From Investors” below.

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