Day trading appeals to investors looking to make a quick profit on short-term price movements in the market. But in addition to the potential rewards, there can also be substantial risks. Critically, day trading has many complex tax implications which can be costly if a proper strategy is not put into place to manage them. It’s important to understand how your trading activities are taxed in order to maximize your tax breaks, minimize your liabilities — and remain compliant.

Tax Rates for Day Trading

Each time you sell for a profit, taxes are owed. Notably, day trading involves a high frequency of sales. With some investors trading hundreds of securities a month, the tax liability can be significant. Importantly, day trading is subject to capital gains taxes. Depending on your overall income and nature of the gains, you may also be subject to the 3.8% Net Investment Income Tax (thanks to Obamacare).

Capital gains can fall into one of two categories — short-term gains and long-term gains. The tax rate for short-term gains held for one year or less can vary from 10%-37% based on your overall income. The tax rate for long-term gains from assets held for more than a year is more favorable, at a rate of either 0%, 15%, or 20%, depending on your income level. However, most of those involved in day trading do not hold assets for a long enough period of time to qualify for these lower rates.

Day Trader Tax Breaks

Most people who buy and sell stocks on the side are considered “investors” by the IRS. However, if you satisfy the IRS’s criteria to qualify for trader tax status, some of the tax impact stemming from day trading can be reduced. To be eligible for this preferential tax treatment, your trading activity must be substantial, regular, and continuous. You must also seek to profit from the daily market movements and intend to trade as a business.

Some strategies a trader may use to reduce their tax burden can include:

• The mark-to-market election — The mark-to-market election changes how gains and losses from trading are recognized. It allows them to be treated as ordinary income or loss, rather than capital gains. Only those who qualify as traders can make this election.
• Wash sales — A wash sale is a transaction where an investor sells a security at a loss and purchases a “substantially similar one” 30 days before or after the sale. While ordinary investors cannot claim tax deductions in these cases, those with trader tax status are not affected by this rule.
• Business expense deductions — Trader tax status allows you to write off reasonable business expenses, such as a home office, computers, software, educational expenses, and many others.

Additionally, forming a business entity such as an LLC or possibly an S corp can have many advantages for those with trader tax status — and is another strategy that can help reduce your tax liability. A formal business structure can ensure your trading and personal finances are kept separate, and you can pay yourself a reasonable salary. You can also reap tax benefits by contributing to a retirement plan and taking deductions for health insurance premiums through the entity.

Contact an Experienced Tax Professional

If you are involved in day trading, it’s vital to have a knowledgeable tax advisor by your side to help ensure you optimize your tax strategy. Based in Fairfield, Connecticut, Rolleri & Sheppard CPAS, LLP offers guidance to investors and individuals with trader tax status to help them reduce their tax burdens and maximize their profits. Contact us online or call (203) 259-CPAS to schedule a consultation.