Day trading can be a fulfilling and lucrative career. If you know what you are doing, you can make a serious change. But with every financial success comes everyone’s favorite consequence: taxes. So how do day traders avoid taxes, or at least reduce them? There are a few different methods you can use if you are day trading to reduce your total tax bill.
If you don’t want to leave things to chance, or you just don’t want to worry about your tax obligations, consider hiring a financial advisor who can handle it for you.
What is Capital Gains Tax?
If you are a successful trader, you will have to pay on your earnings. Any profit made by selling an investment may be subject to what is called capital gains tax. So if you buy a stock for $20 and sell it for $25, you have $5 in capital gains that will be taxed.
Capital gains are taxed at different rates depending on the duration of the investment, also known as short-term and long-term rates. If you buy an asset and sell it within a year of the purchase and your profit, you are taxed at the short-term rate. Essentially, the profit is added to your annual income and taxed at the same rate as your income. Depending on the tax bracket, short-term capital gains are taxed at 10% to 37%.
Long-term capital gains are the profits you’ve reaped after selling an investment you’ve held for over a year. These are taxed at a lower rate of 0% – 20% depending on income. Now that we have capital gains tax defined, we can analyze what it means to be a trader, so that you can take full advantage of the IRS system.
What it means to be a trader
Some people may consider themselves day traders but may not qualify as such under IRS rules. To be considered a trader by the IRS, you must meet three criteria:
Look for profits in daily market movements from stocks, not dividends, interest or capital appreciation.
Engage in a substantial activity.
Continue activity and regularity.
Buy-and-hold investing is not considered trading with the IRS. Traders need to be active, place more trades per day and usually hold stocks for a shorter period. The tax status of a “merchant” requires a lot of work, as well as a lot of money. The IRS will expect you to trade, as well as have substantial funds to trade.
The mark-to-market method
The first way day traders avoid taxes is by using the mark-to-market method. This method takes advantage of the ability of day traders to offset capital gains against capital losses. Investors can get a tax break for any investment on which they have lost money and use it to avoid or reduce capital gains tax. Normally, you can only deduct up to $3,000 in losses. But the mark-to-market method allows traders to deduct more.
If you meet the above criteria for a trader, you can submit an election to mark-to-market your stocks or commodities. This allows you to deduct more than $3,000 in losses and allows you to mark the value of the stock at new market value at the beginning of each year. Essentially, this resets any gains or losses to $0. The downside is that you won’t be able to carry over the losses into the next year. However, the advantages of this method far outweigh the disadvantages.
Use Wash-Salt Exemption
Many investors sell losing assets to offset gains. For this reason, the IRS prevents many investors from selling investments at a loss and then buying the same asset within 30 days of the sale.
If you use mark-to-market, however, you are exempt from this rule. You can offset your gains by selling assets, whether or not you just bought them. Day traders can use this to their advantage. For example, if they assume a company’s stock will drop after the quarterly earnings call in a few days, they can buy the stock and sell it when it drops, counting the loss as a tax deduction. Of course, this comes with risks.
Deduct business expenses
The last method to reduce taxes is to take advantage of the fact that they are running a business. This means they reduce their total tax bill by deducting qualified business expenses from their annual taxes. Things like Internet service, a computer, as well as any commercial software or services can be deducted. If you have a designated home office, you may also be able to deduct part of your mortgage. You can work with a financial advisor who is experienced in working with companies to learn more about how it might work for your situation.
The bottom line
Active day traders can avoid taxes in several ways. By taking advantage of the IRS deduction system, you can reduce your tax burden. If you file a mark-to-market election, you can record losses in excess of $3,000, reset your gains and losses to zero each year, and be exempt from the wash-sale rule. Along with these niche tax breaks, you can claim business-related tax breaks, such as the cost of your investment software or your Internet bill. Once added up, day traders can avoid or at least reduce the amount of capital gains tax they will have to pay.
Tax planning tips
Not sure how your home business expenses or taxes might affect your bottom line? You may want to consider talking to a financial advisor who can help you create the right plan for all of your finances and save on taxes or missed opportunities. Finding the right financial advisor that fits your needs doesn’t have to be difficult. The free SmartAsset tool it connects you with up to three financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you are ready to find an advisor who can help you achieve your financial goalsit begins now.
Since short-term capital gains are taxed at the same rate as your income, one way to estimate how much you’ll have to pay is to calculate federal income taxes. SmartAsset’s Federal Income Tax Calculator is free and easy to use.
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