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Investor or Trader? You decide....

7/17/2017

 
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​Investors enjoy several tax advantages not available for other sources of income. Capital gains rates, tax-free income, like-kind exchanges, and the ability to donate appreciated stock are just a few of the possible benefits available to investors. But investor capital loss rules, on the other hand, can be a significant irritant.
Losses on Schedule D are limited to $3,000 per year. I have one client that lost over $300,000 on an investment. Unless the client has capital gain income to offset the loss, she can claim a $3,000 loss for the next 100 years of her life.
 
When big losses occur, some taxpayers might consider changing their position from being an investor to being a trader. Instead of reporting capital gains and losses on Schedule D, traders report their activity on Schedule C. Losses on Schedule C are deducted in full in the year of sale, making this a tempting proposition compared to the $3,000 per year alternative. Other investment expenses could also be deducted in full on Schedule C, instead of being limited to the 2% threshold for itemized expenses on Schedule A. In a year of big losses, these could be a huge boon to a taxpayer.
 
It should be noted that traders selling stocks for a gain held over a year would lose by being taxed at regular income tax rates instead of the beneficial long-term capital gains rates available when reporting on Schedule D. However, since true traders hold stocks typically for only very short periods of time, this is not an issue to them. It would, however, cause additional tax to an investor claiming to be a trader.
 
The IRS knows that taxpayers may try to claim their activity belongs on Schedule C when they are, in reality, typical investors. The IRS will check the facts and circumstances of a taxpayer’s situation to determine if they are a trader or an investor. If someone has claimed to be a trader, but the IRS determines they qualify as an investor, the income and expenses are reclassified, and penalties will likely be applied.
 
If you are trying to decide if you qualify as a trader, consider the following.
  1. Holding Period. Traders may hold an investment for a very short time, perhaps no more than a day, while investors typically hold for longer intervals, such as months or years.
  2. Frequency. A trader is active and frequent on purchases and sales, perhaps even buying and selling the same stock multiple times a day. Investors are much less active, and make a few trades a month or year.
  3. Livelihood. Traders are buying and selling stocks to make a profit to support themselves. Investors are looking to supplement their income, often for retirement.
  4. Time. A trader’s job is to buy and sell stocks, and as such will likely spend time equivalent to a full-time employee. Investors will research, but most of their time is spent on activities other than investing.
  5. Volatility. Traders look for volatile stocks, where prices rapidly spike, allowing for quick profits. Investors typically look for stocks that will increase in value over the long term.
  6. Risk Tolerance. Traders may sell sooner when prices dip, recognizing that it is time to cut their losses, while an investor may see a small dip as typical in a market, and not be as concerned since they have a longer vision for the investment.
  7. Company Health. Traders buy stocks to make a quick profit. It doesn’t matter if the company is around next week or next month – they just want to make their profit and get out. Investors want to make sure their money isn’t going anywhere, so they typically invest in companies with a solid performance history or strong potential for stability.
 
While this is not an all-inclusive list, it may help you determine whether you can justify calling yourself a trader. If you qualify as a trader there is nothing wrong with reporting your activity as such. Just make sure you have the documentation to support your position, and be prepared to share that with the IRS if they ask you to prove you aren’t an investor.

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