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Stock Trading: Tax Rules and Strategies
Stock Market News
December 1999
Stock Trading: Tax Rules and Strategies
The stock market can offer attractive returns but you must take taxes into account or the results may be a smaller return, no return or you may eventually pay out more in taxes than the gain in the long run. The most important key to remember is how your gains are calculated.
Short term capital gains are figured on an ordinary income-tax basis. Long term capital gains are calculated at 20 percent. To explain, let's look at the following example, which will not take into consideration commissions or transaction fees.
Mr. A has been trading stocks for a year and a day and has been successful to the tune of $20,000. In other words, his short-term gains were $20,000. On the other hand, Mr. B has held onto stocks he owns and has made only one trade after the stock became a long-term holding.
Based on the same dollar amount in gains and the same tax bracket, Mr. A may pay close to 40 percent or $8,000 in taxes. Mr. B would pay only $4,000. If you are in a high marginal tax bracket such as our examples then you may want consider the long-term gains approach.
In the previous example we assumed that Mr. A & B had regular jobs and were part-time investors. What kind of investor you are can make a significant difference in tax deductions, which will affect the overall return on your stock trading.
Investment Tax Deductions
You don't need to be an around-the-clock trader to deduct the cost of investing. You can take deductions related to stock trading activity if you follow some simple guidelines. Investment expenses include: fees for professional investment advice, accounting and legal fees related to investment activities, subscriptions to relevant investment publications, the portion of Internet Service Provider charges incurred to follow and trade investments and your home computer. You may be able to deduct your home office as an investment expense if you are not already taking it as a deduction for self-employment and your investment activities take place in a separate area from your business.
Here are some things you cannot deduct: costs related to tax-exempt securities, trading commissions and travel costs to attend investment conventions, seminars and stockholder meetings as well as the fees associated with those meetings.
In order to take investment expense deductions they must exceed 2% of your Adjusted Gross Income (AGI). Miscellaneous itemized deductions like tax-preparation fees and unreimbursed business expenses may also figure into the 2%.
Following are some general situations to outline how some of the rules work for part-time and full-time traders who do their trading at home.
Part-Time Investor with Full Time Job Outside the Home or No Job
If you fit this category you can deduct expenses directly related to investment activities, subject to the 2% of AGI and itemized deduction phaseout rules.
If you use a home computer and peripheral equipment to manage your investments, you can depreciate the investment-use portion of the cost using the straight-line method; 10% in the first year, 20% in years 2 through 5 and 10% in year 6. Like other investment expenses, the depreciation is thrown in the pot with other miscellaneous itemized deductions and is then subject to the 2% of AGI and itemized deduction phaseout rules.
Purchased software used for investment management can generally be written off over three years or earlier if it becomes worthless. However, programs that are useful for one year or less should be fully written off in the year purchased.
Using your home office for investment management activities will not cut your taxes even though business usage will.
Part-Time Investor Who is Self-Employed and Works in the Home
This is the most difficult area to figure your investment versus business usage and investment tax deductions. You have to be careful or you could be stuck paying tax when you sell your house on the gain you made off the depreciation of your home office.
Your home office expenses, including depreciation if you own your home, qualify as fully deductible expenses if the office is used regularly and exclusively for business and meets one or more of the following criteria:
Do not use your home office for investment management activities or you will violate the "exclusively for business" rules. You must plug the computer in another room if you are working on your personal investments or you could stand the chance of you home office deduction being refused.
To the extent that you use your home computer for personal investment, it can be depreciated. If you use your computer 35% of the time for investments you can depreciate 35% of the cost. Home office deductions are a tricky issue and are covered on this Web site in other articles. Be sure to check with your tax professional to avoid losing your home office deduction or having to pay more taxes on capital gains.
Active Investor with No Other Job
If you meet the trader definition, you can deduct all your investment expenses on schedule C, where you report your interest and dividend income as well. Your capital gains and losses go on schedule D. You can also deduct all of your home office expenses, if you meet the criteria, and you can claim Section 179 instant write-offs for computers and other equipment used more than 50% in your business as a trader.
To be a trader, it takes more than just spending a lot of time investing, according to several court cases dealing with this issue. The courts basically want to see not just a lot of hours trading but lots of trading activity, preferably daily, and they do not like to see a bunch of long-term investments. If you hold what you buy for more than a year you may lose trader status even if you make daily transactions. What they are looking for are people interested in short-term market swings rather than long-term capital growth opportunities or interest and dividend income. It also helps to invest broadly, rather than focusing on just a few industries or companies.
Avoiding the Dividend Tax
Another way to cut taxes on stock trading is to avoid the dividend tax. To do this you must invest through a tax-managed mutual fund. These shares can be acquired through a broker. They are usually invested in steady stocks that pay high dividends such as AT&T, IBM and GM. These stocks tend to rise less in a bull market and fall less in a down market than the average stock.
The way it works, the individual will buy shares in the fund and the fund invests in the stocks. Dividends are not passed through to the investor, so they are not taxed to him. Instead, they are reinvested in further stock purchases. In this way, the fund grows for the investor's benefit.
Check with your tax professional to be sure that you are getting all the tax savings you qualify for.
Short term capital gains are figured on an ordinary income-tax basis. Long term capital gains are calculated at 20 percent. To explain, let's look at the following example, which will not take into consideration commissions or transaction fees.
Mr. A has been trading stocks for a year and a day and has been successful to the tune of $20,000. In other words, his short-term gains were $20,000. On the other hand, Mr. B has held onto stocks he owns and has made only one trade after the stock became a long-term holding.
Based on the same dollar amount in gains and the same tax bracket, Mr. A may pay close to 40 percent or $8,000 in taxes. Mr. B would pay only $4,000. If you are in a high marginal tax bracket such as our examples then you may want consider the long-term gains approach.
In the previous example we assumed that Mr. A & B had regular jobs and were part-time investors. What kind of investor you are can make a significant difference in tax deductions, which will affect the overall return on your stock trading.
Investment Tax Deductions
You don't need to be an around-the-clock trader to deduct the cost of investing. You can take deductions related to stock trading activity if you follow some simple guidelines. Investment expenses include: fees for professional investment advice, accounting and legal fees related to investment activities, subscriptions to relevant investment publications, the portion of Internet Service Provider charges incurred to follow and trade investments and your home computer. You may be able to deduct your home office as an investment expense if you are not already taking it as a deduction for self-employment and your investment activities take place in a separate area from your business.
Here are some things you cannot deduct: costs related to tax-exempt securities, trading commissions and travel costs to attend investment conventions, seminars and stockholder meetings as well as the fees associated with those meetings.
In order to take investment expense deductions they must exceed 2% of your Adjusted Gross Income (AGI). Miscellaneous itemized deductions like tax-preparation fees and unreimbursed business expenses may also figure into the 2%.
Following are some general situations to outline how some of the rules work for part-time and full-time traders who do their trading at home.
Part-Time Investor with Full Time Job Outside the Home or No Job
If you fit this category you can deduct expenses directly related to investment activities, subject to the 2% of AGI and itemized deduction phaseout rules.
If you use a home computer and peripheral equipment to manage your investments, you can depreciate the investment-use portion of the cost using the straight-line method; 10% in the first year, 20% in years 2 through 5 and 10% in year 6. Like other investment expenses, the depreciation is thrown in the pot with other miscellaneous itemized deductions and is then subject to the 2% of AGI and itemized deduction phaseout rules.
Purchased software used for investment management can generally be written off over three years or earlier if it becomes worthless. However, programs that are useful for one year or less should be fully written off in the year purchased.
Using your home office for investment management activities will not cut your taxes even though business usage will.
Part-Time Investor Who is Self-Employed and Works in the Home
This is the most difficult area to figure your investment versus business usage and investment tax deductions. You have to be careful or you could be stuck paying tax when you sell your house on the gain you made off the depreciation of your home office.
Your home office expenses, including depreciation if you own your home, qualify as fully deductible expenses if the office is used regularly and exclusively for business and meets one or more of the following criteria:
- It's your principal place of business
- It's used regularly to meet with clients or customers in the ordinary course of business, or
- It's a separate structure apart from the residence portion of the home
Do not use your home office for investment management activities or you will violate the "exclusively for business" rules. You must plug the computer in another room if you are working on your personal investments or you could stand the chance of you home office deduction being refused.
To the extent that you use your home computer for personal investment, it can be depreciated. If you use your computer 35% of the time for investments you can depreciate 35% of the cost. Home office deductions are a tricky issue and are covered on this Web site in other articles. Be sure to check with your tax professional to avoid losing your home office deduction or having to pay more taxes on capital gains.
Active Investor with No Other Job
If you meet the trader definition, you can deduct all your investment expenses on schedule C, where you report your interest and dividend income as well. Your capital gains and losses go on schedule D. You can also deduct all of your home office expenses, if you meet the criteria, and you can claim Section 179 instant write-offs for computers and other equipment used more than 50% in your business as a trader.
To be a trader, it takes more than just spending a lot of time investing, according to several court cases dealing with this issue. The courts basically want to see not just a lot of hours trading but lots of trading activity, preferably daily, and they do not like to see a bunch of long-term investments. If you hold what you buy for more than a year you may lose trader status even if you make daily transactions. What they are looking for are people interested in short-term market swings rather than long-term capital growth opportunities or interest and dividend income. It also helps to invest broadly, rather than focusing on just a few industries or companies.
Avoiding the Dividend Tax
Another way to cut taxes on stock trading is to avoid the dividend tax. To do this you must invest through a tax-managed mutual fund. These shares can be acquired through a broker. They are usually invested in steady stocks that pay high dividends such as AT&T, IBM and GM. These stocks tend to rise less in a bull market and fall less in a down market than the average stock.
The way it works, the individual will buy shares in the fund and the fund invests in the stocks. Dividends are not passed through to the investor, so they are not taxed to him. Instead, they are reinvested in further stock purchases. In this way, the fund grows for the investor's benefit.
Check with your tax professional to be sure that you are getting all the tax savings you qualify for.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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