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Intraday trading, also known as day trading, is the act of selling stocks for profit within the same day that they were purchased. It’s not for everyone, as it normally requires skill, patience, and a basic understanding of human emotions.
But the most important thing you need to understand if you’re day trading or thinking about doing so is the tax implications that are involved. Day traders must pay taxes, but they’re taxed differently from normal investors.
However, there are many deductions that intraday traders can claim when filing that can help reduce their overall tax bill. Here’s everything you need to know about the tax implications for intraday traders and how this can affect one’s earnings.
Trader vs. Investor
The IRS makes a distinction between traders and investors. Most people who trade stocks are treated as investors by the IRS. But if you’re conducting intraday trading as your main source of income and you’re doing this regularly, then there’s a good chance that you’re a trader and not simply an investor.
This distinction is important because day trading taxes are very different from normal investment taxes. For investors, any income made from an investment that is held for less than a full year (365 days) is taxed under a tax bracket known as short-term capital gains. This income is taxed at a much higher rate than long-term capital gains and is currently set at 15%.
However, while proceeds made from other types of short-term investments fall within the short-term capital gains bracket, profits from intraday trading are taxed differently when you’re a trader.
The IRS does not consider day trading to be a form of investing. Instead, it’s treated as a business practice, which the IRS refers to as “speculative activity.” Profits generated from it are therefore taxed as business income under Section 43(5) of the 1961 Income Tax Act. This means that the day trader tax rate for each person differs based on their income bracket.
This means that it’s lumped together with any income you’ve received from other sources, such as profits from a business or employment income.
How much you’re taxed in total will depend on the amount you make from all these sources throughout the year. Profits gained from trading futures, options, or overnight trading are considered to be non-speculative income but are still lumped together with speculative and other types of income.
Offset with Deductions
One major tax benefit for traders that comes with intraday trading is the opportunity to offset many of your gains by claiming deductions based on expenses.
Since the IRS considers day trading to be a business, the normal business expenses that any company can deduct are deductible for intraday traders as well.
This can include internet and telephone bills, broker fees, accountant services, office equipment, and even rental payments and air-conditioning if you specifically use a property for conducting your trading business.
In some cases, you can also claim up to $3,000 in losses at the end of the year for every trade you made that resulted in a financial loss. Any losses over this amount can normally be carried over to other taxable years.
This is known as a tax loss carryforward. However, it’s important to understand wash sale rules and mark-to-market accounting as well, as these two conditions can change this scenario.
Wash Sale Rule
The one scenario where you can’t claim losses towards your day trading taxes is when you’ve sold a security at a loss and then purchased the same security or one similar to it within 30 days of the sale.
This is known as a “wash sale” and the IRS doesn’t allow this type of claim for one very logical reason. It prevents the potential for fraud because, without this rule, traders could simply sell all their shares in a company and then buy those shares back a minute later just to claim a fictional loss. There would be no material loss if the trader were to sell a stock and then rebuy it at the same price.
As for how similar the security must be to constitute a wash sale, the IRS has defined it as a “substantially identical” security. This would apply to the same security or one that’s similar to it but in a different form.
One way that traders get around the issue of wash sales is by making a mark-to-market election at the end of the year. Mark-to-Market (MTM) is a type of accounting that treats your income as a trader as ordinary income instead of capital income.
The major difference is that gains and losses of capital income are reported on tax form Schedule D (Form 1040), while those from ordinary income are reported on Form 4797 (Sales of Business Property). When you file with mark-to-market accounting, there are many benefits in doing so.
While regular investors can normally only deduct about $3,000 in capital losses against regular income, MTM filers have no limit on the trading losses that they can deduct from regular income.
Also, MTM filers aren’t subject to wash sale rules, which is one of the main reasons many choose to file this way. It’s a consolation for having to pay the day trader tax rate instead of the more preferable long-term capital gains rate.
As a final piece of advice, it’s important that you understand all your tax implications if you’re regularly conducting intraday trading as a legitimate trader.
Navigating all the different tax forms at the end of the year can be a daunting task.
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