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Day Trading Options And Taxes

Updated on August 15, 2012

Attention Day Traders: Uncle Sam Wants His Money

Capital gains taxes affect traders of all sizes and Uncle Sam wants his money.
Capital gains taxes affect traders of all sizes and Uncle Sam wants his money. | Source

Day Trading And Taxes

One misstep that many new traders make is with their taxes. Trading, like every other American activity, incurs taxes and you can be sure the IRS will want you to pay them. There are two primary ways in which trading and investing can affect your taxes and the difference depends on your timeframe, or more to the point, how long you hold your positions.

For long term investors the maze of tax laws is much simpler; for short term traders and day traders the tax laws can be quite a burden. In either case it is advisable to consult with a professional tax accountant who is skilled and experienced with trading, investing and capital gains.

The IRS wants you to pay on all your gains but may make you wait to count your losses.
The IRS wants you to pay on all your gains but may make you wait to count your losses. | Source

Capital Gains And Day Trading Options

Capital Gains Tax is the primary worry for most day and longer term traders. Capital gains are the profits you earn when you close a position for more than you opened it for, in effect when you buy low and sell high. Capital gains tax is the tax the government charges for profits earned through trading.

There are two kinds of capital gains, long and short term. Long term capital gains is of little concern for day traders because it only applies to positions held for one year or longer. Short term capital gains is of more consequence since it covers all trades of less than one year. Currently short term capital gains are taxed at the ordinary income rate around 28%, a little high when compared to the long term capital gains tax of 15%.

Capital Losses

Capital Losses are when you close a position at a loss. Unfortunately, this is bound to happen to even the savviest trader. Long term traders can use these capital losses to offset their capital gains and lower their tax burden. Short term and day trader may not be allowed to do the same if the loss is considered to be a "wash".

Wash Sales And Day Trading Options

The Wash Sale rule is a complicated statute that limits the capital losses you can claim. Basically, you can not sell a security, including options, and claim a loss on them if you then buy back a similar position to replace the one you sold within 30 days of the sale. The IRS will make you carry the loss to the new position and will not count it until the position is sold. It sounds complicated, I know; it is meant to keep traders from realizing a loss from positions they intend to keep.

Novice investors especially vulnerable to falling into the wash sale trap if they are actively buying and selling the same security and its derivatives.The only way to avoid a wash is to wait 31 days after selling a security before buying back the same security or one substantially identical. It is important for tax purposes to keep good records and get good tax advice.

Avoiding The Wash Sale Rule

It is possible to avoid the wash sale rule altogether by taking a break from trading at the end of each year. A pause in trading lasting at least 31 days and including December 31st will stop any wash sales from carrying into the next year and allow any accrued losses to count on your tax returns.


Trader VS Investor

The IRS makes a distinction between traders and investors that could save you big money. When the IRS allows you to file as a trader it is recognizing you as being in the business of trading and allows you to pay tax like a business. This means you claim your investing expenses on schedule C as any sole proprietor would do. If you trade often enough to be classified as a trader you will be able to deduct the costs of newsletters, subscriptions, the home office, computer equipment and professional memberships.

The differences between investor and trader status are murky, leaving a lot of room for interpretation. The basic guidelines for a trader are:

  • Trading is your primary source of income. If you have a job and trade actively you may still be labeled an investor by the IRS unless you are making several trades a day.
  • You have a history of day trading and do so on a regular basis with the intention of profiting from short term swings in the market.

Day Trading And Earned Income

For some reason the IRS doesn't consider money made from day trading to be earned income. This counts for both traders and investors. This means that you don't have to pay self employment tax on money earned through day trading options. This is huge savings that many business owners envy.

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