Many traders don’t take advantage of all available tax breaks. Unfortunately, far too many accountants still don’t know these breaks or the many nuances and pitfalls that accompany them. Before it’s too late, you should lay the groundwork for claiming as many tax benefits as possible for your 2011 tax return, file your elections on time for 2012, and consider an entity and retirement plan to receive more breaks for 2012.
Trader tax status is better than investor status
Business traders are entitled to several tax breaks that are unavailable to investors. By default, the IRS lumps all traders into the category of “investor tax status.” Investors are penalized in the tax code, subject to restricted investment interest and investment expenses (Section 212 and itemized deductions), puny capital-loss limitations against ordinary income ($3,000 per year), wash-sale and straddle loss deferrals, no adjusted gross income (AGI) deductions for retirement and health insurance plans (because trading gains aren’t “earned income”), and fewer opportunities to make valuable tax treatment elections.
Conversely, business traders can deduct unlimited business expenses (Section 162), elect unlimited business ordinary loss treatment on trading losses (Section 475 MTM) — which exempts them from wash sale rules — and form an entity to financially engineer earned income from trading gains. Several other tax-savings doors open up too, such as net operating loss (NOL) carrybacks and forwards, Section 195 start-up costs, education expenses, and home-office deductions.
Profitable business traders generally save around $8,000 in taxes with unrestricted business expense tax deductions. Using a separate trading entity, they can choose to save about $4,000 more with AGI deductions for retirement on the elective-deferral portion of an individual 401(k) plan and health insurance premiums. Traders with more material expenses save much more.
Deducting trading losses is very important, too. Business traders are able to maximize tax benefits from trading losses, whereas investors are stuck with capital loss treatment. (Forex is an exception; by default, forex trades receive Section 988 ordinary gain or loss treatment.) A Section 475 mark-to-market (MTM) accounting election filed by April 15 of the current tax year for existing individuals and partnerships allows business traders to avoid the onerous capital loss and wash-sale loss restrictions, thereby unlocking full NOL carrybacks or forwards to collect large tax refunds. The biggest pitfall for traders is getting trapped with unused trading losses. Brokerage commissions on trades are part of trading gains and losses; they are not separate expenses.
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