Being classified as a trader by the IRS's definition as opposed to an investor can save your client a lot of money come tax time. This is because as a trader, they are allowed to deduct all of their investing expenses, including publication subscriptions, their computer equipment and their home office.
First things first, what exactly distinguishes a trader from an investor? Most of the time the answer to that question is not so clear. The part of the tax code that deals with this area is very fuzzy. The best way to determine if your client is considered a trader or investor by IRS standards is to follow examples set by previous court decisions on the matter. The courts consider your client a trader if they meet the following criteria:
If your client has passed the above test on all accounts, congratulations!! The IRS will probably agree with their assessment that they are a day trader. This title therefore allots them the opportunity to deduct all their investing expenses on Schedule C, like other sole proprietors. This is because they are considered by the IRS to be self-employed and are entitled to the same tax benefits as other self-employed persons. Investors are forced to deduct these expenses on Schedule A where expenses can only be written off if they are in excess of 2% of their adjusted gross income.
Margin account interest can also be deducted on Schedule C as well as, in most cases, an immediate write-off of up to $20,000 in equipment and supplies used in your client's trading activities more than 50% of the time. They may also take a home office deduction as long as they use the space exclusively for trading purposes and the deduction does not throw them into a net loss position. Another great advantage of being a trader is they do not have to pay self-employment taxes on their net profit. This is because capital gains are exempted.
Gains and losses are still reported on Schedule D and your client can still only deduct $3,000 in net capital losses each year. In short, Schedule C will contain no other information (such as income) except for expenses, and Schedule D will contain their trading points.