Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Raise your hand if you’ve ever daydreamed about chucking that nine-to-five (or seven-to-seven) day job for life on some remote–but wifi-enabled–island where you supplement your retirement funds with brilliant day trading. Of course, it’s just a fantasy for most of us, but the allure of regularly trading in and out of stocks or other securities for a living or simply to increase current income continues to attract people during good economic times and bad.

If this is something you’re doing, or considering, a couple of recent Tax Court cases could provide you with some helpful tips on how to go about it in a way that maximizes the tax advantages.

Most people who trade stocks are classified for tax purposes as investors. This means any net gains are going to be treated as capital gains versus ordinary income (good if your net gains are from positions held more than a year) and any investment related expenses (like margin interest, stock tracking software, etc.) are going to be deductible only if you itemize your deductions and in some cases, only if the total of the expenses exceeds 2% of your gross income.

Traders have it better. Their expenses reduce gross income even if they can’t itemize deductions (and not just for regular tax purposes but also for alternative minimum tax or AMT purposes as well). Plus, in certain circumstances, if they have a net loss for the year, they have the ability to claim it as an ordinary loss (so it can offset other income) rather than a capital loss (which is limited to a $3,000/year deduction once any capital gains have been offset). Thus, it’s no surprise that in the two recent Tax Court cases, the taxpayers were trying to convince the court they qualified as traders. Although both taxpayers failed, and got hit with negligence penalties on top of back taxes, the cases provide good insights into what it takes to successfully meet the test for trader status.

The answer is pretty simple. A taxpayer’s trading must be substantial and it must be designed to try to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments.

So, what counts as substantial? While there’s no bright line test, the courts have tended to view more than a thousand trades a year, spread over most of the available trading days in the year as substantial while a few hundred trades, especially when occurring only sporadically during the year is not likely to pass muster. In addition, the average duration for holding any one position needs to be very short–preferably only a day or two. If you satisfy all three of these conditions, then even though there’s no guarantee (because the test is subjective), the chances are good that you’d ultimately be able to prove trader versus investor status if you were challenged. Of course, even if you don’t satisfy one or more of the three, you might still prevail but the odds against you are presumably higher.

If you have any questions about this area of the tax law, feel free to contact us.