September 2019

What You Trade Can Make A World Of Tax Difference

September 29, 2019 | By: Robert A. Green, CPA | Read it on

There’s a bevy of financial products to trade with a wide assortment of tax treatment. Traders have access to U.S. and international equities, futures and other Section 1256 contracts, options, ETFs, ETNs, forex, precious metals, foreign futures, cryptocurrencies, and swap contracts. Broker-issued Form 1099-Bs might not provide the best available tax treatment, and in some cases, there are no 1099s issued.

Securities
Securities traders have ordinary tax rates on short-term capital gains, wash sale loss adjustments, capital-loss limitations, and accounting challenges.

Securities include:
- U.S. and international equities (stocks)
- U.S. and foreign equity (stock) options
- narrow-based indexes (an index made up of nine or fewer securities)
- options on narrow-based indexes
- securities ETFs structured as registered investment companies (RIC)
- options on securities ETF RICs
- commodities ETFs structured as publicly traded partnerships (PTP)
- volatility ETNs, structured as debt instruments
- bonds
- mutual funds
- single-stock futures

Securities don’t include:
- Section 1256 contracts
- precious metals (collectibles)
- ETFs structured as publicly traded trusts (PTT)
- CBOE-listed options on ETF PTPs and ETF PTTs
- CBOE-listed options on ETNs
- volatility ETNs structured as prepaid forward contracts (PFC)
- cryptocurrencies (intangible property)
- forex (spot and forwards contracts)
- swap contracts

The IRS taxes securities transactions when a taxpayer closes an open trade – hence the term “realization method.” Taxpayers can defer capital gains by holding open securities positions at year-end.

With “tax-loss selling,” investors realize losses before year-end. Be careful not to re-enter those positions within 31 days; otherwise, the planned tax loss might defer to 2020 as a wash sale loss adjustment.

Short-term capital gains (STCG) use ordinary tax rates, currently up to 37% for 2019 and 2020. Long-term capital gains (LTCG) rates are significantly lower, and they apply to sales of securities held for 12 months or more. The LTCG rates are 0% for the 10% and 12% ordinary brackets, 15% in the middle brackets, and 20% in the top 37% bracket. (See 2019 Tax Brackets.)

The mark-to-market (MTM) accounting method is different. MTM taxes realized and unrealized capital gains and losses at year-end. Traders eligible for trader tax status (TTS) are entitled to elect Section 475 MTM ordinary gain or loss on securities and or commodities. (See How Traders Get Enormous Tax Deductions, And Investors Do Not.) Section 1256 contracts have MTM by default. (See 1256 contracts below).

Capital losses, including capital loss carryovers, offset capital gains without a limitation. A net capital loss for the year is limited to $3,000 against other income like wages. Capital loss carryovers don’t expire; they are deferred tax assets. If you have excess capital losses, don’t rush to elect Section 475 ordinary income as you need capital gains to use up capital losses. Look at all sources of capital gains, including sales of real property and intangible property. Trading entities and hedge funds can pass capital gains to the owner’s tax return.

Section 1256 Contracts
Section 1256 contracts enjoy lower 60/40 capital gains tax rates, summary tax reporting, and easier mark-to-market accounting.

Section 1256 contracts include:
- U.S. regulated futures contracts (RFCs)
- options on U.S. RFCs
- U.S. broad-based indexes made up of 10 or more underlying securities – also known as stock index futures
- options on U.S. broad-based indexes
- foreign futures if granted Section 1256 treatment in an IRS revenue ruling (see list)
- non-equity options (a catchall)
- CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
- CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
- CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
- forward forex contracts with the opt-out election into Section 1256(g) on the major pairs, for which futures trade (we make a case for spot forex, too)
- forex OTC options (Wright court)

Section 1256 contracts have lower 60/40 capital gains tax rates: 60% (including day trades) subject to lower long-term capital gains rates, and 40% taxed as short-term capital gains using the ordinary rate. At the maximum tax bracket for 2019 and 2020, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary bracket of 37%. There are significant tax savings throughout the income brackets. The LTCG rate in the lowest two ordinary brackets is 0%. (See our table Section 1256 tax rates vs. ordinary rates.)

Section 1256 contracts are marked-to-market (MTM) daily. For tax purposes, MTM reports both realized activity from throughout the year and unrealized gains and losses on open trading positions at year-end. The 1099-B is one page with summary reporting.

There is a Section 1256 loss carryback election. Rather than use the 1256 loss in the current year, deduct 1256 losses on amended tax return filings, applied against Section 1256 gains only. Form 1045 is better than 1040X. It’s a three-year carryback; unused amounts carry forward. TCJA repealed most NOL carrybacks, so this is the only remaining carryback opportunity for traders. (See Trading Futures & Other Section 1256 Contracts Has Tax Advantages.)

Options
Tax treatment for options is diverse, including simple (outright) and complex trades with multiple legs.

Options taxed as securities:
- equity (stock) options
- options on narrow-based indexes
- options on securities ETFs RIC

Options taxed as 1256 contracts:
- non-equity options (a catchall)
- options on U.S. regulated futures contracts and broad-based indexes
- CBOE-listed options on commodity ETF publicly traded partnerships (PTP)
- CBOE-listed options on precious metals ETF publicly traded trusts (PTT)
- CBOE-listed options on volatility ETN prepaid forward contracts and ETN debt instruments
- forex OTC options (Wright appeals court)

Generally, options listed on a commodities exchange, a qualified board or exchange (QBE), are a 1256 contract unless the reference is a single stock or a narrow-based stock index. A securities ETF RIC is like a stock in this regard.

Three things can happen with outright option trades:

- Trade option (closing transaction).
- The option expires (lapses).
- Exercise the option.

There are special rules for the holding period for long-term capital gains. (See Tax Treatment Can Be Tricky With Options and ETFs.)

Exchange-Traded Funds (ETF)
Securities, commodities, and precious metals ETFs use different structures, and tax treatment varies.

Securities ETFs: Securities ETFs are registered investment companies (RICs). Selling a securities ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment on the realization method. As a security, wash sale loss adjustments or Section 475 apply if elected.

Commodities ETFs: Commodities ETFs use the publicly traded partnership (PTP) structure. PTPs issue annual Schedule K-1s passing through Section 1256 tax treatment on Section 1256 transactions to investors, as well as other taxable items. Selling a commodity ETF is deemed a sale of a security, calling for short-term and long-term capital gains tax treatment using the realization method. It’s a security, so it’s subject to WS losses and a 475 election if elected.

Taxpayers invested in commodities ETFs should adjust cost-basis on Form 8949 (capital gains and losses). That ensures they don’t double count Schedule K-1 pass-through income or loss. Form 1099-B and trade accounting software do not make this adjustment, so you need to make a manual adjustment.

Physically backed precious metals ETFs: They usually choose the publicly traded trust (PTT) structure (also known as a grantor trust). A PTT issues an annual Schedule K-1, passing through tax treatment to the investor, which in this case is the “collectibles” rate on sales of physically-backed precious metals (such as gold bullion). Selling a precious metal ETF is deemed disposition of a precious metal, which is a collectible. For collectibles held over one year (long-term), sales use the “collectibles” rate —capped at 28%. Short-term capital gains use the ordinary rate. Precious metals and ETFs backed by precious metals are not securities, so they are not subject to WS loss adjustments, or Section 475 if elected.

Forex
Forex transactions start off receiving an ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). Ordinary losses are generally better than capital losses, providing the trader has other income to absorb the loss. With eligibility for TTS, an excess ordinary business loss is a net operating loss (NOL) carryforward.

Section 988 allows traders to file a capital gains election to opt-out of Section 988 ordinary treatment. It must be done contemporaneously in your books and records. You can make, or retract, the opt-out election on a “good to cancel” basis at any time during the year. If you have a capital loss carryover, then consider a capital gains election.

The capital gains election on forex forwards allows the trader to use lower 60/40 capital gains rates in Section 1256(g). There are two requirements: It must be on “major currencies,” and the trader must not take or make delivery. “Major currencies” means currency pairs, which also trade as futures on U.S. commodities exchanges. We make a case for including “spot” forex in Section 1256(g). (See A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.)

Foreign futures
By default, futures contracts listed on international exchanges are not Section 1256 contracts. If the international exchange wants Section 1256 tax treatment, they must obtain an IRS Revenue Ruling granting 1256 treatment. Only a handful of international futures exchanges have Section 1256 treatment: Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada. Foreign futures are otherwise ST or LT capital gains. (See Tax treatment for foreign futures.)

Precious metals
Physical precious metals are “collectibles,” which are a particular class of capital assets. If you hold collectibles over one year (long-term), sales are taxed at the “collectibles” tax rate — capped at 28%. (If your ordinary rate is lower, use that.) If you hold collectibles one year or less, the short-term capital gains ordinary tax rate applies no different from the regular STCG tax rate.

Volatility products
There are many different types of volatility-based financial products to trade, and tax treatment varies.

CBOE Volatility Index (VIX) futures are Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF), taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN).

Volatility ETNs. Many issuers structure volatility ETNs as prepaid forward contracts (PFC), which provides a deferral of taxes until sale (realization). Long-term capital gains rates apply if held 12 months or longer. (i.e., VXX). However, prepaid forward contracts are not securities. Therefore, they are not subject to WS loss adjustments and Section 475 if elected. Many 1099-Bs treat ETN PFC as securities subject to WS. Consider departing from the 1099-B with footnote disclosure. Some ETNs, like UGAZ, are debt instruments taxed as securities, which means they are subject to WS losses and Section 475 if chosen. (Check the tax section of the ETN prospectus and see Other Financial Products.)

Cryptocurrencies
Selling, exchanging, or using cryptocurrency triggers capital gains and losses for traders. The IRS treats cryptocurrencies as intangible property; not a security or a commodity.

The realization method applies to short-term vs. long-term capital gains and losses. If you invested in cryptocurrencies and sold, exchanged, or spent some during the year, you have to report a capital gain or loss on each transaction. Include cryptocurrency-to-currency sales, crypto-to-alt-crypto trades, and purchases of goods or services using crypto.

U.S. cryptocurrency exchanges issue a Form 1099-K to accounts with transactions over a certain threshold. The problem for the IRS is that many cryptocurrency transactions on exchanges around the world are not evident for tax reporting. Cryptocurrency investors should download all crypto transactions into a crypto accounting program that is IRS-compliant.

Wash sales do not apply to intangible property. Use the first-in-first-out (FIFO) accounting method. Intangible property should use the specific identification method, but that requires broker confirmation of each trade, which is not possible.

TCJA restricted Section 1031 like-kind exchanges to real property, starting in 2018. That rules out using like-kind exchange on crypto-to-crypto trades (i.e., Bitcoin for Ethereum). It’s questionable whether crypto traders could have used Section 1031 before 2018 to defer capital gains taxes. The IRS promised the public more advice on crypto, and it recently mailed tax “education” notices to crypto traders. I hope the IRS addresses Section 1031, hard forks or chain splits, and several other open questions. (See Watch Out Cryptocurrency Owners; The IRS Is On The Hunt.)

Swap contracts
The Dodd-Frank financial regulation law promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown. Remember those credit default swaps with insufficient margin? When Congress enacted Dodd-Frank, traders hoped that clearing on futures exchanges would allow Section 1256 tax treatment. They were wrong: Congress and the IRS immediately communicated that Section 1256 would not apply to swap transactions, and they confirmed ordinary gain or loss treatment.

Roger D. Lorence JD contributed to this blog post.

Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update

For more information on wash sales and Section 475, see How Traders Get Enormous Tax Deductions, And Investors Do Not.

For more in-depth information, see Green’s 2019 Trader Tax Guide


How Traders Get Enormous Tax Deductions, And Investors Do Not

September 28, 2019 | By: Robert A. Green, CPA | Read it on

Traders eligible for “trader tax status” (TTS) deduct business expenses, startup costs, and home office deductions. A TTS trader may elect Section 475 for exemption from wash sale loss adjustments (deferrals), the $3,000 capital loss limitation, and to be eligible for a 20% qualified business income (QBI) deduction. Trading income is not self-employment income, so TTS traders don’t owe SE taxes. Using an S-Corp, TTS traders create earned income to maximize health insurance and or retirement plan deductions.

Lacking TTS, investors get peanuts in the tax code. TCJA, the new tax code suspended investment fees and expenses along with all other miscellaneous itemized deductions subject to the 2% floor. Two itemized-deductions for investors survived tax reform: Investment-interest expense limited to investment income, and stock-borrow fees. With the state and local tax (SALT) limitation and roughly-doubled standard deduction, many investors don’t get any tax deductions for investment-related expenses.

The IRS does not permit investors to elect Section 475, so they are stuck with wash sale loss adjustments, and the $3,000 capital loss limitation. Short-term capital gains are subject to ordinary tax brackets. Investors benefit from long-term capital gains, providing the investor holds a position open for 12-months or more. Long-term capital gains rates are 0%, 15% and 20% for 2019 and 2020. Traders can have segregated investments for LTCG, too. 

How to qualify for trader tax status
Satisfy the below requirements based on my analysis of tax court cases and years of experience working with traders. 

· Substantial volume – at least four total trades per day, 15 per week, 60 per month, and 720 per year annualized (Poppe court). Count open and closing trades separately.
· Frequency – a trade execution on 75% of available trading days. That’s close to four days per week.
· Average holding period under 31 days (Endicott court bright-line test).
The above factors are the “big three.”
· Continuous trading with few sporadic lapses.
· Time – four hours per day, including trading, research, and administration.
· Intention to run a business and to make a living. It doesn’t have to be a primary living.
· Business setup (multiple trading devices, monitors, and a home office).
· Materiality (Pattern Day Trader minimum for securities of $25,000; $15,000 otherwise).

Assess your facts and circumstances for TTS towards the year-end. If you rise to the level of TTS, then deduct business expenses, startup costs, and home office expenses on Schedule C, a partnership, or S-Corp tax return. TTS business expenses do not require an election with the IRS; whereas, Section 475 does require a timely election. TTS does not convert capital losses into ordinary losses; a Section 475 election is necessary for ordinary gain or loss treatment. 

TTS business expenses
If you are eligible for TTS, you are entitled to deduct the below items, and more:

· Tangible personal property up to $2,500 per item, including computers, monitors, desks, and mobile devices.
· Section 179 (100%) depreciation, 100% bonus depreciation, and or regular depreciation.
· Amortization (expensing) of startup costs (Section 195), organization costs (Section 248), and software.
· Education expenses after the commencement of TTS.
· Section 195 startup costs may include education expenses within six months of beginning TTS.
· Publications, subscriptions, market data, charting services, self-created automated trading systems, cloud computing, professional services (accountants and attorneys), chat rooms, mentors, coaches, supplies, media, communications, travel, meals, seminars, conferences, supplies, assistants, office rent, and consultants.
· Home-office expenses for the business portion of your home. (See Home Office Tax Deductions Are Fantastic: Learn How To Do It.)
· Margin interest expenses. (Not limited to investment income like investment interest is.)
· Stock-borrow fees and other costs for short-sellers.

Wash sale loss adjustments
Wash sale loss adjustments on securities cause headaches and potentially higher tax bills. If a taxpayer repurchases substantially identical securities within 30 days before or after realizing a tax loss on securities, the IRS uses the wash sale (WS) loss rule. That defers a tax loss to the replacement position’s cost basis.

For example, if you sell Apple stock at a tax loss on December 15, 2019, and repurchase a substantially identical position (Apple stock or option) on January 10, 2020, the 2019 wash sale loss defers to 2020. It’s critical to avoid WS at year-end in taxable accounts by breaking the 30-day chain. Sell the position by year-end for a tax loss, and don’t repurchase a substantially identical position for 31 days. If you want to catch a rally in January, then consider it may not be so bad to defer a loss as it’s just a timing issue.

It’s essential to prevent WS losses throughout the year between taxable and IRA accounts because it’s a permanent WS loss. The IRS does not allow a WS loss to be added to cost basis in the IRA. 

There are other ways to avoid WS. TTS traders can elect Section 475 on securities to be exempt from WS. Traders can choose to trade instruments that are not considered securities, including futures, forex, precious metals, and cryptocurrencies. 

WS rules for taxpayers and brokers are different. The IRS requires taxpayers to calculate WS losses based on substantially identical securities positions (i.e., Apple equity vs. Apple options), across all taxpayer’s brokerage accounts, including IRAs and spousal accounts if married/filing joint. Conversely, the IRS requires brokers to calculate WS based on identical securities (an exact symbol) per the one brokerage account. This apples vs. oranges is problematic since the IRS seeks to match broker 1099-Bs with taxpayer Form 8949s. Many accountants and taxpayers do not know these differences in the rules. Consider trade accounting software that is compliant with IRS rules for taxpayers, and you should explain overall differences in tax return footnotes. (See How To Avoid Taxes On Wash Sale Losses.)

Elect Section 475 for additional tax benefits
The IRS permits TTS traders to elect Section 475 ordinary gain or loss treatment on securities and or commodities. Section 475 trades are exempt from wash sale loss rules, and the $3,000 capital loss limitation. Short-term capital gains use the same ordinary rate as Section 475, except 475 also unlocks a potential QBI deduction. There are significant tax benefits on Section 475 ordinary losses vs. capital losses. TTS traders can deduct a 475 ordinary business loss against wages and other income; thereby bypassing the capital loss limitation. Excess ordinary losses are a net operating loss (NOL) carry forward.

TCJA introduced a 20% qualified business income (QBI) deduction for sole proprietors, partnerships, and S-Corps. TTS trading is a “specified service trade or business” (SSTB) subject to a taxable income threshold, phase-in and phase-out range, and taxable income cap. If you exceed the taxable income cap, you don’t get a QBI deduction on an SSTB. QBI includes Section 475 income/loss net of trading business expenses; whereas, QBI excludes capital gains/losses, interest, dividends, and other investment income. (See A Rationale For Using QBI Tax Treatment For Traders.)

Most futures traders prefer to skip a 475 election to retain Section 1256 60/40 capital gains rates; they don’t want ordinary income. However, if you have a significant trading loss in 1256 contracts, then consider a 475 election on commodities. You can revoke a Section 475 election in a subsequent year, in the same manner, you elected it. (See more about Section 475 and how to choose it in my blog post, Traders Elect Section 475 For Massive Tax Savings.)

Join my upcoming Webinar on October 23, 2019, or watch the recording after to learn more about this content: Trader Tax Strategies 2019 Year-End Update

For more in-depth information, see Green’s 2019 Trader Tax Guide


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