The stock market is one of the very few places on earth that does not discriminate against people based on education, experience, ethnicity, and societal status.
The market is supreme, and it treats every trader alike.
With free stock trading, you can make unlimited profits if you have the right expertise. Similarly, you can lose the entire capital if you do not possess the right skills.
But, when it comes to taxes, the Internal Revenue Service, which is the nodal authority for collecting taxes, does discriminate between the experienced and the amateur, the investor, and the trader.
Irrespective of your position in the market, one thing is certain – the more you earn, the higher taxes you have to pay.
Read on to find out more about the various taxes a day trader has to factor in before calculating their profits or losses.
Are You a Day Trader or an Investor?
In the US, day traders and investors are taxed differently. So, even before knowing the taxes that apply to you, figure out whether you are a day trader or an investor.
You are an investor if you buy stocks today and sell them tomorrow. You are as well an investor if trading every day is not your cup of cake.
You are a day trader if you buy or sell stocks every day the markets are open. You are also a trader if you prefer to capture short-term swings rather than relying on dividend income or long-term value appreciation in the stock price.
The Perks of Being a Day Trader
While there is no way to escape taxes, being a day trader can give you a slight edge in managing your finances. You may also apply for the designation of Trader Tax Status, or TTS, which would make trading and tax filing much more convenient.
If you are a day trader, the tax authorities would most likely consider you as self-employed and allow you to claim deductions under Section-C, applicable for a sole proprietor.
According to this clause, you may claim tax deductions on all trading related expenditures, which include margin account interest, journal subscriptions, computer, phone bills, bookshelves, desk, fax machine, and so on.
Additionally, you may claim deduction on your home-office if you use it exclusively for trading. However, make it a point to keep all receipts handy, as the IRS may ask for proof to determine whether you are eligible to claim such deductions or not.
Another provision that applies exclusively to a day trader is that they can write off all their losses by classifying themselves as mark-to-market traders.
Generally, all investors and traders can claim deduction on losses of up to $3000 every year. However, if you buy the same stock, which you used while calculating losses, within thirty days, then the ‘Wash Sale’ rule applies to you, and you might not be able to claim deduction on the entire loss amount.
If, however, you become a ‘mark-to-market‘ trader, the provisions of wash sale rule would not apply to you.
Let us understand this with an example.
Imagine you bought 10 stocks of ABC Finance at $50 per share on December 1, 2019. On December 31, the stock rose to $100, thus fetching you a $500 profit. However, you decided not to sell it.
On January 5, 2020, you sold it at $120/share. Hence, the total profit you earned from this trade is $600. If you are an investor following the capital gains accounting method, the entire $600 profit you made would be reported in the 2020 tax file, for which you have to file returns in 2021.
If, however, you choose to opt for the mark-to-market accounting method, then the IRS would assume that you have booked your profit or loss on December 31, irrespective of whether you hold the stock after December 31 or not, and you would be required to pay taxes only for the amount that you gained till December 31, in April 2020.
The same formula applies for calculating and claiming a deduction on losses. The biggest benefit of being a mark-to-market trader is that it acts as a cushion in case the year has been especially bad for you, and you have lost more than $3000 due to erratic market conditions.
The Day Trader Tax Jargon
Being a day trader who is liable to pay taxes every year, you would come across various jargon, which would seem difficult. The following is a list of the terms you should know to make your tax filing easier.
1. Cost Basis
This is the amount you pay to purchase a stock. It includes everything from commission to other charges. If you sell the stock above the cost basis, then you have made a profit, and vice versa.
2. Capital Gains or Losses
Capital Gains refer to the amount you make by selling stocks above the cost price. Capital gains can be of two types – short-term and long-term. Generally, short-term capital gains tax rate is higher than long-term capital gains.
Capital losses refer to the amount you lose by selling stocks below the cost price. As an investor, you may claim deduction on losses of up to $3000 a year. If, however, you are a trader, then you may claim deduction on the entire loss amount by applying the provisions of the mark-to-market accounting method.
The Tax Reporting Process
Reporting taxes on day trading is not as difficult as it seems at first.
As a trader trading in the US stock market, you will have to use Form 8949 and Schedule D to report all your capital gains and losses.
You may use Schedule C to declare the expenses and Schedule D to declare the profits.
The Best Way to Keep Record of Transactions
As a day trader, it can be extremely difficult to keep track of all your purchase and sale orders.
During tax filing, the IRS would not only ask you about your net profit or loss, but also stock details, cost, transaction date, sale price, and sale date.
To make the process easy, you may consider buying a financial software. The software would automatically download the trade records and compile your report, thereby making the tax preparation process much less complex.
Making consistently healthy profits is the dream of all-day traders. But not all can become so successful.
If you have been struggling to make consistent profits, then Alpaca’s trading view charts can help you to establish yourself as a successful day trader.
Considering all tax benefits and money-making opportunities that the stock market can provide, there is no doubt that trading is the best profession you can consider for attaining financial freedom.