Trading Down

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.