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Investing in securities (stocks, bonds, mutual funds, etc.) may prove to be an effective way of turning cash into profit. It is a fact, though, that it takes a lot of knowledge and experience for anybody to become a profitable investor, and there is always a certain amount of risk involved. Most investors prefer to turn to professional brokers to make sure they invest their money in a nice, balanced, profitable portfolio.
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But what is the difference between investors and traders? And why does it matter?
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As you may have guessed, we shall turn to the IRS to clarify these terms from their point of view.
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- Investors typically buy and sell securities and expect income from dividends, interest, or capital appreciation. They buy and sell these items and hold them for personal investment; they are not conducting a trade or business. Most investors are individuals. Sales of these securities result in capital gains and losses that must be reported on Form 1040, Schedule D, Capital Gains and Losses, and on Form 8949, Sales and Other Dispositions of Capital Assets, as appropriate.
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Investors are subject to the capital loss limitations and may be able to benefit from a deduction for the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are reported on Schedule A, Itemized Deductions, as miscellaneous deductions to the extent that they exceed 2% of adjusted gross income. Interest paid on money to buy or carry investment property that produces taxable income is also deductible on Schedule A, but under section 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities.
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Dealers in securities may be individuals or business entities. Dealers purchase, hold, and sell securities to their customers in the ordinary course of their trade or business. Sometimes they maintain an inventory.
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Dealers are distinguished from investors and traders because they have customers and derive their income from marketing securities for sale to customers. Because they are in the trade or business of buying and selling, the gains and losses of dealers are classified as ordinary gains and losses. IRS regulations requires that dealers keep and maintain records that clearly identify securities held for personal gain versus those held for use in their business activity.
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| Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. This is considered a business, even though you do not maintain an inventory and do not have customers. |
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To be engaged in business as a trader in securities, you must meet all of the following conditions:
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- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
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- Your activity must be substantial; and
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- You must carry on the activity with continuity and regularity.
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The following facts and circumstances should be considered in determining if your activity is a securities trading business:
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- Typical holding periods for securities bought and sold;
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- The frequency and dollar amount of your trades during the year;
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- The extent to which you pursue the activity to produce income for a livelihood; and
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- The amount of time you devote to the activity.
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Traders report their business expenses on Form 1040, Schedule C, Profit or Loss From Business. The Schedule A limitations on investment interest expense, which apply to investors, do not apply to interest paid or incurred in a trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities.
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| If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a "day trader," you are an investor. |
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| A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to the securities held for investment. |
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A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader's records on the day he or she acquires them (for example, by holding them in a separate brokerage account).
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Traders are entitled to an option not extended to investors: the usage of the mark-to-market rules. To explain, the tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under section 475(f) to use the mark-to-market method of accounting. If the mark-to-market election was not made, then the gains and losses from sales of securities are treated as capital gains and losses that must be reported on Schedule D. When reporting on Schedule D, both the limitations on capital losses and the wash sales rules continue to apply. However, if the mark-to-market election was timely made, then the gains and losses from sales of securities are treated as ordinary gains and losses (except for securities held for investment) that must be reported on Part II of Form 4797, Sales of Business Property. Further, neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.
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Trading gains and losses whether as an investor or in the business of trading are not subject to the self-employment tax, which is a combined social security and medicare tax.
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| The bad news is that you cannot make a retirement plan contribution based upon your trading. The IRS does not consider trading gains as "earned income", which is a prerequisite for making a contribution. This includes any contribution to an Individual Retirement Account (IRA); 401K Plan; Simplified Employee Pension Plan (SEP); or any other type of pension plan. |
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| You can though, contribute to a retirement plan if your trading business is set up as a separate entity such as a corporation. Your trading gains could then be paid to yourself as a salary, which qualifies as earned income. |
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These are only a few details about investors and traders, things may get more complicated and to navigate through the maze of IRS regulations you definitely need a tax professional, as we always advise you for all your dealings with the IRS.
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