Think You Are A Trader? IRS Says Think Again.

by MB on September 3, 2008

Even if you make hundreds of trades per year, the IRS may not consider you a “trader” for tax purposes.

This is according to an article in today’s Wall Street Journal titled: “Think You’re A Trader? IRS May Disagree.”

It details a Florida couple who formed a trading company and performed over 660 trades over a two year period. They formed a separate company to perform transactions, and claimed losses in both years as well as other company related expenses.

Traders, as defined by the IRS, have different tax rights than individual investors. Income they earn on their trading activities cannot be treated as capital gains and is therefore taxed as normal income at higher rates. However, traders using the mark to market method of accounting are allowed to treat any losses they suffer as ordinary losses instead of capital losses. Normal investors are allowed to offset capital losses with capital gains on a dollar-for-dollar basis. In cases where losses exceed gains, the investor is only allowed to deduct $3,000 per year ($1,500 if married filing separately) with the remainder carried forward into future years.

In order to be considered a trader by the IRS one must meet two criteria: (1) trading activity has to be substantial, and (2) traders must be attempting to profit from daily swings in the market. (For further information see: IRS Tax Topic 429)

In the case of the Florida couple, the judge found that they did not meet either of these criteria, and therefore, were not eligible to deduct the full amount of their losses. The judge in the case also disallowed other deductions the couple had claimed.

This should underscore the ramifications that can occur when you step outside the normal bounds of taxable activities. Be sure to seek professional advice, and always try to err on the side of caution.

The full decision can be read here.

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