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Financial Planning > Tax Planning > Tax Loss Harvesting

Trading Down

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Four years ago, Congress gave stock traders a little- known bonus: under certain circumstances, they could write off all of their trading losses, not just the token amount afforded casual investors. Instead of being limited to $3,000 net capital losses against ordinary income, they could write off losses against all income. They could get rid of the wash sale rule. And they could write off more margin interest and other investment expenses. No one paid much attention to this so-called Section 475(f) election, because the stock market was soaring. But now, what’s also known as mark-to-market accounting looks more interesting. “The current losses in the stock market have generated a lot of interest in this election,” says Mark Luscombe, an analyst with Commerce Clearing House in Chicago.

Ironically, it was Democrat Bill Clinton who created the loophole. Certainly, the 2001 Bush tax cut hasn’t helped traders. Long-term capital gains rates stayed at 20%, while short-term capital gains tax rates fell from a high of 39.6% to 39.1% for the rest of 2001, and 38.6% for 2002. Net capital losses were still limited to $3,000 per year against ordinary income. The wash-sale rules remain, so stock can’t be sold at a loss, the write-off taken, and the stock bought back within 30 days. And expenses associated with investment activities are still considered a “miscellaneous itemized deduction,” the total of which must exceed 2% of adjusted gross income to count.

In contrast, the Taxpayer Relief Act of 1997 allowed qualifying traders to eliminate capital losses and the wash sale rule, a privilege previously bestowed exclusively on securities dealers. Instead of being limited to $3,000 in write-offs against ordinary income, the trader could treat losses as ordinary, which means that they could offset income from all sources. Net operating losses could be carried back two years and forward 20 years. Investment expenses would not be subject to the 2% AGI limitation.

However, there was one catch. The individual has to be considered a true “trader.” For tax purposes, people who buy and sell securities are categorized in one of three boxes: dealers, traders, or investors. Since neither IRS guidelines nor the Internal Revenue Code define traders, the courts have created facts and circumstances tests. In general, a trader is primarily interested in the gains derived from speculating on securities. In contrast, investors are primarily interested in income from long-term appreciation, interest, and dividends. What constitutes a trader is becoming a hot topic among CPAs.

At one end of the spectrum, there’s the person who does nothing but sit at a terminal all day, every day, and trade. At the other end, there’s a person with a full-time job in another field who dabbles on weekends. “Your trading has to be continuous,” says Michael Andreola, a tax partner with BDO Seidman in New York. “If you’re doing one or two trades a month, then you don’t qualify,” he says. “If you’re doing a few hundred trades a month, then you have a strong argument. But 20-30 transactions a month is questionable.”

“Since the IRS doesn’t tell us what a trader is, then we can only go back to past tax court cases,” says Vern Hoven, a CPA in Missoula, Montana, who gives tax seminars on this and other subjects to CPA societies. He cites one case in which a person had 326 transactions in the year, generating a loss of $10.8 million. The court considered him an investor, not a trader, because he took three months off for vacation. “You have to look at the frequency, extent, and regularity of transactions, the taxpayer’s investment intent and the nature of the income derived,” Hoven says.

He cites the following cases in his course materials: “To qualify as a trader instead of an investor, taxpayers must prove that they are engaged in purchasing and selling stock regularly, frequently, and in substantial volume, and that they seek profit from the daily swings in the market movement, rather than from long-term appreciation and income (Paoli, Stephen vs. Comm., TC Memo 1998-23). Other courts have considered such factors as the frequency, extent and regularity of the securities transactions; the taxpayers’ investment intent; and the nature of the income derived from the activity (Mayer v Comm., 94-2 USTC; Moller vs. U.S., 83-2 USTC.)”

“There is no clear definition of the word trader,” agrees Luscombe. “It’s certainly someone dealing for their own account and not with customers, but the point at which one becomes a trader versus an investor is not clear,” he says. “In my view, it’s someone who seeks to generate current income through trading versus someone with a longer-term view who is investing with a long-term goal in mind like retirement.”

Since short-term capital gains are taxed the same as ordinary income under traditional rules, there’s little lost by selecting mark-to-market accounting and doing away with short-term capital gains. For traditional investors, investment interest expense can only be deducted to the extent that it exceeds investment income. Making the election allows you to deduct all investment interest expense. In addition, all subscriptions, news services, investment seminars including travel costs, computer expenses, telephone, office supplies, and furniture are deductible. The trader can also have long-term investments, but they must be held in a different account, preferably with a different brokerage house. Long-term capital gains treatment is available in this separate investment account. As a bonus, trading profits are not subject to self-employment or Social Security tax. The election is irrevocable, but as a practical matter, all a trader would have to do is close the account and open a different one if he or she wanted to revert to investor status.

The IRS requires the taxpayer to apply for mark-to-market accounting under Section 475(f) by April 15th of the year that the taxpayer wants it to be effective. For instance, you would have to make the election by April 15th, 2002, to receive the tax treatment for the 2002 tax year. Mark-to-market accounting also requires you to count unrealized gains and losses at the end of the year. On December 31, you’ll be required to take an inventory of your securities that have appreciated and depreciated since you bought them and either pay tax on the difference if there’s a net gain, or take a loss if there’s a net loss. If you’re a truly active trader, then you shouldn’t have too many open positions on any given day.

When it first came out, the Section 475(f) election could be made retroactively. So a trader could look back on a prior year, see a bunch of losses, and decide that it would be nice to categorize losses as ordinary rather than capital. However, the IRS issued regulations in 1999, Revenue Procedure 99-17, that tightened up the rules. Bernie Kent, a CPA with PricewaterhouseCoopers in Detroit, recalls saving a trader millions of dollars in taxes by making the Section 475(f) election after the year was over. “The election allowed him to treat the losses as ordinary rather than capital, and he was able to use his other income in that year as an offset,” Kent recalls.

If the taxpayers’ activities meet the qualifications of a securities trader, and a timely Section 475(f) election is made, then all security gains and losses are treated as ordinary income or loss, courtesy of the Taxpayer Relief Act of 1997. All securities on hand at year-end are deemed to be sold at the year-end market value, thus forcing recognition of any unrealized gains and losses. At the beginning of the next taxable year, the taxpayer’s adjusted bases of all securities are marked up or down to their fair market value at the close of the prior year. There are no unrealized gains and losses at the beginning of the new year.

For example, Bob, a trader who made a timely Section 475(f) election, purchased 1,000 shares of on December 15, 2001, for $20,000. At the close of business on December 31, 2001, the securities were worth $15,000. He sells the securities on January 2, 2002, for $15,000. He reports a $5,000 loss on his 2001 tax return, and his adjusted basis on January 2, 2002, is $15,000. If Bob’s dot.bomb shares were worth $23,000 on December 31, 2001, he would report a $3,000 gain on his 2001 tax return, even if the shares weren’t sold until January 2, 2002. If the shares are sold on January 2, 2002 for $15,000, then he reports a loss of $8,000 in 2002, because the shares have a basis of $23,000.

To elect the mark-to-market method of accounting, taxpayers must file Form 3115, “Application for Change in Accounting Method.” Once the election is made, it cannot be revoked without the consent of the IRS. For the Section 475(f) election to be effective for the year 2002, a taxpayer must attach Form 3115 to her 2001 return and file the return by April 15th, 2002, or attach it to her Form 4868 extension request for her 2001 return.

To convert to mark-to-market accounting, a Section 481(a) adjustment must also be made. That adjustment is the difference between the fair market value and the adjusted basis of the securities as of the close of the year prior to the election year. For example, if you elect Section 475(f) for 2002 and you have a portfolio with a fair market value of $300,000 on December 31, 2001 but an adjusted basis of $350,000, then the $50,000 unrealized loss can be written off over the following four years. If the adjustment is less than $25,000, then it can be done in the current year.

“I see no downside to making this election,” says Hoven, who does not believe that it is a red flag for an IRS audit.

Okay, let’s say I have a regular job and trade every weekend. Am I a trader? “No problem, I’d sign your tax return,” Hoven says. Just follow three basic rules: trade regularly, trade extensively, and generate short-term gains.