Few Day Traders Taking Advantage Of New Law

Date: 11/26/99
Author: Peter McKenna

The day trader, formerly a target of the U.S. Congress, has now become its new best friend.

Congress, through the tax code, has long provided incentives to investors who build wealth by leaving their money in stocks for the long term while penalizing those, like day traders, who turn money over frequently.

When day trading became popular in 1996, Congress instructed the Internal Revenue Service to treat these rapid-fire traders as hobbyists rather than professionals engaged in a business.

Under the tax code, losses by day traders and other investors were limited to the amount of their capital gains plus $3,000. If a day trader suffered a huge loss, it was the price that had to be paid for taking a short-term approach to investing.

Then, in 1997, Congress had a change of heart.

What happened? ”Day trading is the American dream right now,” said Robert Green, president of Green & Co., a CPA firm in Ridgefield, Conn., that specializes in tax problems faced by day traders. ”A lot of intelligent people are leaving their chosen professions to sit in their pajamas in a house in the woods and trade stocks.”

These traders, Green says, are injecting huge amounts of capital into the stock market, particularly new high tech and Internet companies. This cash inflow is helping these upstart companies build and expand. If and when these companies become profitable, they will pay taxes on their earnings.

Day traders who actually make money are also paying taxes on their profits, creating more income for Uncle Sam.

”Congress realized that day traders are good customers for the IRS, even though they are not professional securities dealers who have customers and offices on Wall Street,” Green said. ”They generate taxable wealth and inject capital into the system, so Congress decided that they deserve the same tax breaks that apply to professional traders.”

In 1997, under the Taxpayer Relief Act of 1997, day traders gained the right to deduct 100% of their losses and 100% of their expenses, including margins, such as interest fees, the cost of computers and software, tax advice and educational expenses.

”If a day trader loses $1 million, he can deduct $1 million under a Schedule C tax form, just like any other businessman. It comes right off the top of taxable income,” Green said. ”Day traders are now businessmen.”

Green says that many investors and accountants are unaware that Congress gave day traders business deductions in 1997.

”Day traders are not a respected class of client among many accountants,” Green said. ”The accountants don’t really want their business, so they don’t bother staying abreast of the tax laws. Even a lot of the IRS accountants still haven’t gotten the word about the new rules.”

As yet, the IRS has not provided detailed guidance on who is and who is not a day trader. Generally, the IRS will consider you a day trader if the only way you earn income is to trade stocks for your own personal account, and if you hold your positions for a very short period of time.

”Day trading is not sneaking a trade or two when the boss is not looking,” said Stanley Stall, head of Stall & Co., a Bellmore, Long Island, accounting firm. ”If the only way you put bread on the table is by day trading, you are a day trader. But the trading has to be frequent, regular and continuous. And you should hold your positions for less than 30 days. If you hold a position for more than 30 days, the IRS will consider you a long-term investor.”

While the IRS has not yet said an investor must make a certain number of trades per year to qualify as a day trader, accountants say day traders should make at least one trade per day to keep the IRS happy.

”I prefer to see about 300 trades per year,” Green said. ”We prepared returns for more than 200 day traders last year, and 95% qualified as day traders.”

To qualify as a day trader, an investor must also notify the IRS by April 15 that they intend to use mark-to- market accounting rules. Without this declaration, a day trader would not be able to deduct business losses and expenses.

”Mark-to- market is a way of closing out a position at the end of the year so the books can be balanced,” Green said. ”Let’s say a day trader bought 100 shares of Microsoft at 75 on Dec. 25. By Dec. 29 the price is up to 80. For tax accounting purposes, it will be assumed that the trader sold the stock at 80 on the last day of the year, realized the gain and then bought it back at 80 on Jan. 1.”

Online traders who make fewer than 300 trades a year and who do not choose the mark-to-market option will likely be refused by the IRS if they try to qualify for day-trader status.

”These traders will fall under the old rules,” Green said.

Day traders are allowed to hold stocks for the long term if they are held in a separate account and not day traded. The trader must tell the IRS these long-term positions exist and they are not assets of a day- trading business.

While they have gained the right to treat their trading as a business, traders still face the highest tax rate when they pay tax on their profits.

To qualify for the long-term capital gain rate of 20%, a stock has to be held for a year and a day. None of the profits made by day traders will qualify for this rate. Instead, day traders are taxed at their ordinary federal income tax rate, which could be as high as 39%.

Keeping good records is vital for day traders if they want to take advantage of their business deductions.

”You have to keep your long-term accounts separate from your day-trading accounts, and you have to have records to show the IRS,” said Stall. ”We tell our clients every time they buy or sell a stock, they should e-mail the particulars to themselves. That way they have a time and date stamp to show the IRS.