Tax Advantages of Being a Trader

Do You Actively Trade Securities or Cryptocurrencies[i]? If so, have you considered a “Mark to Market” election for income tax purposes? Are you a “trader” or an “investor”?

A client of mine brought me a letter he received from his discount broker. They sent him a letter to let him know that they considered him a “trader” and he wanted to know what that meant. He made over 1,200 trades last year as he actively managed his portfolio. His accountant told he was subject to the “Wash Sales” Rules (IRC Sec 1091 and 475(b) , discussed below. He wanted to know if there was a way of avoiding the Wash Sales treatment. I told him there is, if he qualifies as a “Trader” he could make a “Mark to Market” election. His accounting professional was unaware to the election. 

This note assumes that the reader is not a ”dealer” in Securities. A “Dealer” is defined as a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business. Only Dealers and Traders can make a Mark to Market Election, Investor cannot. What is the difference between a Trader and an Investor and why should you care?

Who is an Investor? The basic rules concerning capital gains and losses apply to investors, who report their gains and losses on Schedule D. The mark-to-market rules and the possibility for ordinary loss treatment are not available if the taxpayer is considered an investor. In adtion the “Wash Sales” rules  apply to Investors  See Secs. 1091 and 475(b).

Who is a Trader? The IRS has set forth the following criteria to qualify as a “Trader”. The taxpayer must meet all of the following tests:

• The taxpayer must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
• The activity must be substantial; and
• The activity must be carried on with continuity and regularity.

The following facts and circumstances must be considered in determining whether the activity is a securities trading business:

• Typical holding periods for securities bought and sold;
• The frequency and dollar amount of trades during the year;
• The extent to which the taxpayer pursues the activity to produce income for his or her livelihood; and
• The amount of time devoted to the activity

What is a “security”? The term “security” is broadly defined to include a share of stock; a partnership interest; a beneficial interest in a trust; a note, bond, debenture, or other evidence of indebtedness; and certain other contracts or positions. Certain securities are exempt from Sec. 475 treatment (e.g., the constructive sale). The issue, which is yet to be resolved, is whether cryptocurrencies qualify as a ”security”. The IRS determined that cryptocurrency is “Property” (Notice 2014-21) but has not gone further in its characterization. This issue, is, therefore, yet to be determined. There are certain forms of investment in cryptocurrency like ETF’s ,that are securities, but the issue overall remains unsettled. When in doubt, make the election

Why Make a Mark to Market Election? Under the mark-to-market rules, dealers and eligible traders are treated as having sold all their securities on the last day of the tax year at their fair market value (FMV), causing gain or loss to be taken into account for the year. Any gain or loss recognized under this rule is taxed as ordinary income or ordinary loss. This rule is extremely valuable because it allows traders (who make the election) to avoid the limitation on the deduction of capital losses. By making the election, traders can use losses to offset all other taxable income without limitation. Moreover, because these are business losses, traders can add to or create a net operating loss that they can carry back two years and forward 20 years. The wash sales rules do not apply.

How do I make a Mark to Market Election? There is no special form for making the election. Instead, the taxpayer simply files a statement containing certain information. For elections effective for tax years beginning on or after January 1, 1999, and not requiring a change in accounting methods (e.g., the first year of business), the statement must include the following: 

• A description of the election being made (i.e., the election under Sec. 475 to use the mark-to-market method of accounting);
• The first tax year for which the election is effective; and
• The trade or business for which the taxpayer is making the election.

What if I failed to make the election timely. Section 9100 provides relief for a late election based upon “reasonable cause”. Reliance on the written advice of an accounting  professional or lawyer can be adequate, however, the issue of professional malpractice is outside the scope of this blog,

Conclusion: True traders should consider a Mark to Market election for their “trading activities.

[i] IRC §475(f)