Day trading can be a fulfilling and lucrative career. If you know what you’re doing, you can make a serious chunk of 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 that you can use if you’re day trading to reduce your total tax bill.
If you don’t want to leave things to chance, or just don’t want to worry about your tax obligations, consider hiring a financial advisor who can manage it for you.
What Is the Capital Gains Tax?
If you’re a successful trader, you’re going to have to pay on your earnings. Any profit you earn selling an investment could be subject to what is called the 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 how long you held the investment, also known as short-term and long-term rates. If you buy an asset and sell it within a year of buying it and your profit, you’re taxed at the short-term rate. Essentially, the profit is added to your yearly income and taxed at the same rate as your income. Depending on your tax bracket, short-term capital gains are taxed at 10% – 37%.
Long-term capital gains are profits you collected after selling an investment you held for over a year. These are taxed at a lower rate of 0% – 20% depending on your income. Now that we’ve defined capital gains tax, we can break down what it means to be a trader, so you can take full advantage of the IRS system.
What it Means to Be a Trader
Some people might consider themselves day traders but they may not qualify as one under the IRS rules. To be considered to be a trader by the IRS, you must meet three criteria:
Seek profits in daily market movements from securities, not from dividends, interest or capital appreciation.
Engage in substantial activity.
Carry on the activity and regularity.
Buy-and-hold investing isn’t considered trading to the IRS. Traders must be active, making multiple trades a day, and usually holding securities for a shorter period. The tax status of a “trader” requires a lot of work, as well as a lot of money. The IRS will expect you to be making trades, as well as having substantial funds for trading.
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 with capital losses. Investors can get a tax deduction for any investments they lost money on and use that 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 file an election to mark-to-market your securities or commodities. This allows you to deduct more than $3,000 in losses and lets you mark the value of the security to the new market value at the start of every year. Essentially, this resets any gains or losses to $0. The downside is that you won’t be able to carry over losses into the following year. However, the advantages of this method far outweigh any downsides.
Use the Wash-Sale Exemption
Many investors sell off losing assets to offset gains. Because of this, 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’re using mark-to-market, however, you’re exempt from this rule. You can offset your gains by selling off assets, regardless of whether you’ve just purchased them. Day traders can use this to their advantage. For instance, if they speculate a company’s stock is going to dip after their quarterly earnings call in a few days, they can buy the stock and sell it when it dips, counting the loss as a tax write-off. Of course, this comes with risk.
Deduct Business Expenses
The last method of reducing taxes is by taking advantage of the fact that they are operating a business. This means that 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 software or trading services can possibly all 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 businesses to learn more about how it could work for your situation.
The Bottom Line
Active day traders can avoid taxes in a few different ways. By taking advantage of the IRS system of deductions, you can lessen your tax burden. If you file an election to mark-to-market, you can record losses over $3,000, reset your gains and losses yearly and are exempt from the wash-sale rule. Along with these niche tax deductions, you can file for business-related tax deductions, such as the cost of your investing software or your internet bill. When added up, day traders can avoid or at least reduce the amount of capital gains tax they will have to pay.
Tips for Tax Planning
Unsure how home business expenses or taxes may affect your bottom line? You may want to consider speaking 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 hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Since short-term capital gains are taxed at the same rate as your income, one way to estimate how much you’ll need to pay is to calculate your federal income taxes. SmartAsset’s federal income tax calculator is free and easy to use.
Photo credit: ©iStock.com/dima_sideInikov, ©iStock.com/Antonio_Diaz, ©iStock.com/ArLawKa AungTun
The post How Day Traders Can Reduce Taxes appeared first on SmartAsset Blog.
#Day #Trader #Reduce #Taxes