The Internal Revenue Service distinguishes between investors and traders. If you want to trade securities as a sole proprietor, you must meet IRS requirements regarding your intent and activity. If you qualify as a trader, you must observe special tax reporting rules and may make certain elections that affect your tax bill.
Traders vs. Investors
To qualify as a trading business, you must seek profit from the daily ups and downs of the market. This excludes income from interest, dividends and securities held for investment. You have to show substantial and regular trading activity. The IRS will examine your typical holding period, the size and frequency of your trades, the role the business plays in earning you a livelihood and the amount of time you spend trading. If you don't meet these criteria, the IRS will consider you an investor, and you'll file your expenses on Schedule A of Form 1040.
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As a stock trader, you report your expenses on Schedule C. Do not deduct commissions as an expense. Rather, add them to the cost basis of your trading securities and subtract them from sale proceeds. You don't have to limit interest expense deductions to your investment income, as is the case for investors. Your trading gains and losses are not subject to self-employment tax. Use Form 8949 to report your capital gains and losses, and summarize the information on Schedule D. However, use Form 4797 if you elect mark-to-market reporting.
A stock trader can choose mark-to-market reporting. Under this election, you report all gains and losses as ordinary income rather than capital gains. To qualify, you must treat securities that you own at the end of the year as if you sold and repurchased them at their final market value on the year's last trading day. This creates ordinary gains and losses that you report on Form 4797. Exclude any securities you're holding for investment, and ignore wash sale rules when you elect mark-to-market reporting. This means you can deduct a trading loss even if you repurchase the same security within 30 days.
If you want to use mark-to-market reporting, file a statement with your income tax return telling the IRS you are making the election under section 475(f) of the Internal Revenue Code. You must file the form before using this election. Once you make the election, it will continue to apply to all future years unless the IRS agrees to revoke it. In addition to the wash sale benefit, electing mark-to-market reporting allows you to take a business loss when your trading losses exceed your gains. Under capital gains reporting, you could apply only $3,000 of excess losses to ordinary income and then carry any remaining capital losses forward to future years.