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List,
This post taken from a very informative discussion in March about trading
and taxes. It makes informative points regarding a trader's tax
obligations. It may be of interest to some since the tax season is right
around the corner. For a more in-depth discussion of this topic I would
strongly recommend reading Ted Tesser's book The Trader's Tax Survival
Guide.
B
-----Original Message-----
From: Dave [mailto:yankee93@xxxxxxxxxxxxxxxx]
Sent: Thursday, March 19, 1998 8:10 AM
To: omega-list@xxxxxxxxxx
Subject: Re: Trader tax laws...what are they?
This is a follow up message from my original post last night; again, sent to
me from another forum by a trading buddy.
Dave
TSC Tax Forum: TSC Revisits and Revises Its Tax Comments for Day Traders
By Tracy Byrnes
Staff Reporter
3/18/98 3:59 PM ET
This is a bonus TSC tax forum, which usually appears on Saturdays. We first
revisit an important day trader issue and then move on to general questions.
* * * * *
Day traders: we gave you some information in our Tax Forum last week that
could lead you down a difficult -- some say wrong -- path. We're sorry, and
we need to clear it up.
Actually, we wish we could clear it up neatly and cleanly. But it's about
Schedule C versus Schedule D for folks filing as "traders." And frankly,
it's a lot more of a gray area than we thought in our column last week. As
more and more people file as day traders, the trend is getting a bit ahead
of the law.
Thanks to readers who wrote in response to our comments about which schedule
traders should report their gains and losses on, we went back to several
professionals. After receiving different answers from the pros, we called
the IRS. After putting us on hold for 45 minutes, the agency said "It
depends." Oh, that helps.
But we finally found sources that helped us get you some good guidance.
Before we proceed, we need to remind you that, at best, for any tax
question, we can only give general guidance. Only you and your accountant
can figure out exactly what's right for you.
* * * * *
Your emails questioned the validity of traders' reporting everything --
trading gains, losses and expenses -- on Schedule C, as we said traders
could and should do.
This approach is recommended by some practitioners, including Ken Strauss of
Morrison, Brown, Argiz, the third largest non-"Big-Six" accounting firm in
Florida. He says that this is how they deal with their clients who are
traders. "I have had clients who were audited, and this practice was
permitted," says Strauss.
But up until the Tax Payer Relief Act of 1997, most folks we've since spoken
to do not do it this way.
Putting that law aside for a moment, "the correct way is to take all your
trading gains and losses on Schedule D," says Ted Tesser, a Boca Raton CPA
and the author of The Trader's Tax Survival Guide.
This therefore means that all losses are limited to the amount of gains,
plus up to $3,000 of ordinary income.
TSC readers Dennis Mykytyn, Michael Gartenberg and Steven Herscovitz pointed
out that, to the best of their knowledge, that's exactly what a trader is
supposed to do.
Richard Shapiro, an Ernst & Young tax securities partner, agrees --
Schedule D is generally the way to go. But -- and there is always a "but" --
thanks to the Tax Payer Relief Act of 1997, if you are a trader, you have a
new choice. You can elect to report your trades on a "mark-to-market" basis.
According to Section 475(f) of the Internal Revenue Code, this election
allows you report everything -- which means gains, losses and expenses -- on
Schedule C. Gains are then treated as ordinary income subject to ordinary
rates. And you generally will not be subject to self-employment tax, so
Social Security is a non-issue, says Will Taggart, a Coopers & Lybrand tax
partner in the financial services group. (For more information, refer to the
Technical Report HR2645.)
Under this mark-to-market method, you have to value your portfolio at
year-end as if you were selling it. Your basis in each security will then be
adjusted to its current fair market value.
There are two major pros to this method:
* If you had a really bad year, then electing mark to market may be a great
thing. Since everything is reported on Schedule C -- even losses -- there is
no limit to the amount of losses you can report. You're losses can be huge.
It doesn't matter. Take them all.
* Another bonus to the mark-to-market method: no wash sale rules (see the
previous piece for details, but note that it's a good thing).
And here are the cons:
* If you had a great year, then valuing your holdings at year-end may bring
you lots of unrealized profits on any positions you're holding. That could
mean big taxes.
* If you trade futures, commodities and/or non-equity options, you may lose
the luxury of the 60/40 Rule. If, for example, you are a commodity trader,
you may qualify under Section 1256 of the Internal Revenue Code, which says
that you can utilize the 60/40 Rule on your Schedule D. Under this rule, 60%
of your trades are considered long term (held for more than 18 months) and
40% are considered short term, regardless of the actual time held. "Even if
you hold a option for one day, 60% is long term and 40% in short term,"
notes Tesser.
Here's the kicker: You can't switch back to Schedule D next year -- not
without petitioning the IRS, that is. Tesser points out that once you chose
"mark-to-market" status, there is no turning back. You can't use it when you
have losses only and then elect to use Schedule D when you have gains.
You're either mark to market for the long haul or you're not.
So sit with your accountant and think twice about this election. And if you
decide to take it, here's some fun thanks to the IRS: There's no box to
check off to make the election. You have to include a statement attached to
your return.
Regardless of whether you choose the new election or not, Tesser says that
if you are a trader, you can deduct all your related investment expenses on
Schedule C. Again, that's pretty cool because an investor -- in contrast to
trader -- must report expenses on Schedule A, and the benefit of the
deduction may be limited based on total adjusted gross income.
Whether you elect mark to market or report your gains and losses on Schedule
D, you are not subject to self-employment tax. You do not qualify for the
Keogh under this status either.
Note that our prior report on this point, too, was misleading. We said you
could qualify for the Keogh. And perhaps you could. Strauss tells us he uses
Schedule C for his clients without mark to market and says they qualify for
a Keogh. But other sources insist you should only touch C if you mark to
market, and if you proceed in that fashion, you don't qualify for a Keogh.
(As an aside, Tesser notes, that if you own or lease a trading seat on an
exchange you will be subject to self-employment taxes. Again, check with
your accountant.)
Reader Dennis Mykytyn also questioned whether it was proper to just attach
your brokerage statements to your Schedule D in lieu of rewriting every
trade, as we had said. Our sources say attaching the statements is common
practice. But if you keep your own records and believe that your schedules
are just as valid, you may attach these instead. That's what Mykytyn does,
and he says he's never had a problem. Bottom line: Do whatever you can to
make the folks' lives at the IRS simpler.
If, in the end, you're still confused about whether you even qualify for
trader status, Tesser's firm in Boca Raton will send you a free 20-question
evaluation to help you pinpoint your status. They will even discuss the
evaluation with you. He's at (561) 392-9232.
More Tax Fun for Regular Folks
Here are some of the answers to your general questions. Thanks to Bill
Fleming, director of personal financial services at Coopers & Lybrand, and
Chris Nardone, principal tax consultant at Price Waterhouse, for all their
help.
Do We Split 50/50?
If two people manage an account (both names are on the account) how are
capital gains taxes accounted for? Would each party pay taxes on the full
amount or would they split the gains in half and render each party 50%
liable? Or is there some other way in which these amounts are calculated?
Thanks for your help!
* Matt O'Neill
Matt,
Each party is liable for all related income and expenses up to the
percentage they contributed to start the account. So if you put in $60 and
your friend put in $40, then you are responsible to declare 60% of all
related income and expenses on your tax return. Your friend gets only 40%.
Question is: How many Social Security numbers are on account? If there are
two, the IRS will be looking for both of you. But if there is just one, then
the IRS will expect to see all the qualified income and expenses on that
person's tax return. Fleming says you must notify IRS about the other party.
"Make a note on the face of return."
Quickly call it to the agency's attention, and show the agency the whole
calculation, Fleming says. First include the total amount of capital gains
due and deduct the amount you are liable for. Then show that the balance is
to be paid by the taxpayer you share the account with. Be sure to include
the person's Social Security number.
Take from One Hand and Give to the Other?
Could capital losses offset interest and dividends? For example, I have a
loss from selling stocks but I have $200 in income from interest and
dividends on that account. Can the capital loss offset the $200 income so
that I don't pay tax on the interest and dividends?
* Roger Deng
Roger,
As long as you got 1099s for both the interest, dividends and the capital
gains, the government knows about all of it. Therefore it all must be
reported. As for an offset, that depends on variables like whether the
capital loss is long- or short-term, whether the income is taxable or tax
free, and what your tax bracket is, says Nardone.
Don't Tell Me I Owe MORE!
I am going to owe an additional $1,000 on my 1997 tax return, due to capital
gains on the sale of stocks. Will I have to pay a penalty on this
underpayment?
* John Tracy
John,
This is a good question. According to the U.S. Master Tax Guide, paragraph
2682, in order to avoid an underpayment penalty, you must have paid a
specific amount of tax by year-end. Through withholdings or estimated
payments, you must have paid 90% of the tax shown on your current 1997 tax
return OR 100% of your 1996 tax bill (110% if your adjusted gross income was
more than $150,000 for joint filers and $75,000 more single guys) by
December 31, 1997. If you didn't, you will likely be penalized.
If you do owe in the end, Form 2210 -- Underpayment of Estimated Tax can
help cut the penalty by annualizing income. Be sure to read the
instructions.
Make sure you think about all this for next year so you can avoid any future
penalties. You might want to consider starting to make estimated payments
for 1998 now.
When in Doubt, Just Give it Away!
Say a guy holds an investment for more than 12 months but less than 18. The
price of the stock has gone up 80% in that time. He decides to give the
stock to a charity. Is there any benefit to the taxpayer by waiting for 18
months to donate it versus donating it today (do not concern yourself with
the fact that the stock may go down waiting the additional time). Does this
affect the size of the deduction he would get if you waited the additional
time?
* Jeffrey Margolies
Jeffrey,
As long as you've already held the shares for a year and a day, the shares
are considered long term for charitable purposes. No difference between 12
and 18 months. This then means you can get a charitable deduction for these
shares equal to the fair market value of the shares on the day you donate.
If you held the shares for less than a year when you make your donation,
your deduction is equal only to your cost basis (what you paid for them).
When calculating your donated fair market value, though, you must take the
average of the stock's high and low price at the close of the day you donate
the shares. This amount goes on your Schedule A - Itemized Deductions. If
your donation is more than $500 you must also file Form 8283 - Noncash
Charitable Contributions.
Read IRS Publication 561 -- Determining the Value of Donated Property for
more info.
Name That Property
What exactly is the difference between "Investment Property" and "Rental
Property?" I have just completed building a house that I cannot now live in.
In order to best decide "if and how" to hold it, it would be good to
understand the tax treatment, and any items deductible, under each of these
scenarios.
* John L. Settles
John,
Because rental property is actually a form of investment property, the basic
difference lies in the intent, says Fleming. "What do want to do with it?"
Do you want to hold it or rent it? "If you rent the property out you can
deduct the rent, interest, property taxes, repairs and maintenance and any
applicable depreciation on Schedule E -- Supplemental Income and Loss," says
Nardone. If it's an investment property, you can only deduct the real estate
taxes.
It seems renting is better, but realize that "it may be hard to sell
property that's rented," notes Fleming. It may be easier to hold as an
investment property until the time of sale.
Ah, the Infamous Home Equity Loan Interest
When is the interest on a home equity loan deductible? I can't get a decent
answer from the IRS.
* Ron Coleman
Ron,
The general rule is that interest on a home equity loan up to $100,000 is
deductible.
When you take out a home equity loan, you are borrowing against the equity
you have in that residence. According to the U.S. Master Tax Guide,
paragraph 1048, as long as the loan doesn't exceed the fair market value of
the house, you can deduct the interest.
But paragraph 1048A says that the deduction is limited. If your loan is for
$125,000 and that is less than the fair market value of the residence, then
the interest on the first $100,000 is deductible, no problem. For the
balance of the loan, you have to ask, "What did you use the money for?" says
Fleming. If you put the money into the house, then the interest is
deductible. If you bought a car with the remaining $25,000, then it's not.
Help! I've Changed My Mind!
Can the basis of a stock sold be changed after I filed my tax return
already? It would result in paying more tax in 1997 and less in 1998. I had
a choice on the basis because I sold a partial position. I am willing to pay
more tax in 1997 in order to reduce my 1998 tax. This would allow me to
qualify for a rollover to a Roth IRA. The stock in question is being bought
out for cash forcing the liquidation in 1998. The buy-out had not been
announced when I filed originally. THANKS!
* Steve Utley
Steve,
You can always try to amend your return. However, if you chose to amend,
Fleming says to wait until after April 15 when the IRS begins to clear its
plate.
Tuition Reimbursement in Disguise
Your old employer E&Y gave me a check when I joined the management
consulting group that covered all of my second-year tuition for my MBA.
There were NO taxes taken out. If I leave before one year has lapsed my
graduation date I have to repay the firm, after that all is forgiven. How do
I treat this on this 1997's taxes? As a no interest loan? Ignore it? As
tuition reimbursement?
* Andy Martines
Andy,
Talk to E&Y. Find out how they are classifying this check. They could be
calling it a training expense, and then it wouldn't be taxable to you. But
if it's an education expense to them, you could have tax implications.
So your first step should be to the HR department.
Margin Interest, Again!
Exactly where on your tax form do you deduct interest paid on a stock
purchased on margin?
* Bob Hunter
Bob, Check out the Options Forum, from two weeks ago, when we hit this topic
then. Basically, the interest goes on Schedule A -- Itemized Deductions and
is limited by the amount of investment income you have. But read the Forum
for the whole scoop.
TSC Tax Forum aims to provide general tax information. It cannot and does
not attempt to provide individual tax advice. All readers are urged to
consult with an accountant as needed about their individual circumstances.
TSC TAX FORUM
Tax Forum Debuts with Special Feature for Day Traders
3/14/98 0 AM
(c) 1998 TheStreet.com, All Rights Reserved.
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