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Tax Loopholes for Stock Investors/Traders

Taxes and regulation

Diane Kennedy

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It's nice to see the traders on the forum. This post is for you!

I talk a lot about the tax loopholes available for business owners and real estate investors and, to be honest, tend to ignore the stock investors/traders. That's largely because most of my client base are business owners and/or real estate investors. And, frankly, there aren't that many strategies for stock investors.

Here's a few of the things to look at:

- If you pay a management fee on your account, it'll be an "investment expense" which means it's only deductible to the extent of your investment income AND ends up flowing through on your Schedule A...which might be limited due to your income. It's better to have fees that are related to buying and/or selling so that the expense is deductible as part of the basis (if it's related to the buy) or cost of sale (if it's related to the sell).

- If you are an "active trader" you can make an election to turn your investing/trader into a business. That means you can move all of the expenses (computer, home office, education, etc) into a regular business and they'll then be fully deductible and not subject to any limitations or phase-outs. There isn't a hard and fast rule on what it takes to be active, but in general the IRS wants to see 3 things:

(1) Short swings. You are holding a majority of your trades for less than 3 months. Tax Tip: If you have two strategies - both long term and short term, move the long term into a separate business structure so that they are reported differently on your tax return.

(2) Amount of Trades: Generally, you'll need 500+ trades per year to make the grade here. There has been a court case that denied the designation with someone who had 500 trades, but the problem was with (3) below - not the number of trades.

(3) Regular and consistent trading: Once you start your trading business, stay consistent. Having a very busy July and then nothing for the rest of the year isn't going to work here.

If this works, get with your tax advisor to file your election. It's called "mark to market" and can get you some great tax benefits.

If there's interest on the forum, I can post a Part 2 on how you do this election and what recent court cases have said about late elections.
 
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CarrieW

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I am very interested in this...

I would appreciate anything you can post on this subject!
 

Rawr

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Thank you very much for posting this!

I am new to the capital gains tax idea and have some basic questions if you don't mind.

What do I do if I lose money for the year?

How can IRS check if I trade any stocks and if I've made gains?

Can I write off computer and may be some electric bills without forming a business?

Thank you
 

CRBFL

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Not like you need it Diane, but Speed ++

You're awesome!
 
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Diane Kennedy

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Thank you very much for posting this!

I am new to the capital gains tax idea and have some basic questions if you don't mind.

What do I do if I lose money for the year?

How can IRS check if I trade any stocks and if I've made gains?

Can I write off computer and may be some electric bills without forming a business?

Thank you

Rawr, you've got some good questions.

If you lose money, you're going to be limited to $3,000 of loss against your other income. Losses offset gains first and then you can take just $3,000. Any excess loss can carry forward into the next year.

You will receive a Form 1099 on the gross sales price for stocks you have traded. It's up to you to report the basis on that stock. If you don't, then it's assumed that it's ALL gain...and the IRS will want you to pay tax on that amount.

On write-offs - this is where stock investing isn't the best tax strategy. These deductions are limited to the amount of gain, after being subject to miscellaneous deduction limitations on your Schedule A. Bottomline, you probably can't take the write-off.

The exception is if you can qualify as a trader - then you have a business and can take regular business deductions.
 

Rawr

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Thanks for the response Diane,

I hope you don't mind if I post my situation to get more insight:

I've actually lost money (so far) on the recent stock purchases so it seems I will be down for the year. My regular income is not over $4000 which I believe the cut off for reporting it is in MN. So do I need to report anything at all? If I didn't make any money from my job, can I get any additional money from my losses or is that used only if I have taxable income?

Thanks Again!
 

Diane Kennedy

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Hi Rawr:

It depends on the 1099 you receive in January. My guess is the gross sales amount + your other income will put you over the limit, so you'll have to file.

The fact that you had basis that means the sale was really a loss, doesn't matter to the IRS. All they get reported is the gross sales amount...so as far as they know you might actually have a gain.

It will push you into a loss overall (I'm guessing) which means you'll have a loss carryforward from the stock. That's fine - because it's there for when you have a gain on other investments...hopefully in 2008!
 
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Diane Kennedy

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I am very interested in this...

I would appreciate anything you can post on this subject!

Hi Carrie:

What are you doing with trading now? Let me know and maybe I can give you some tax help before year-end.

Diane
 

CarrieW

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Hi Carrie:

What are you doing with trading now? Let me know and maybe I can give you some tax help before year-end.

Diane


Awe thank you so much!!!

right now i am in my planning stage. ive just finished up about 18 months of studying and research into forex trading...

I am looking to have my business plan done by years end and start live trading in about february to march of 2008. unless it takes me longer then i think to get where i want to be in my demos, i absolutley refuse to trade with my own money untill i can make money for 2 months using my actual starting conditions in the demo...(I really want to make a career out of this im not looking to play around and lose money lol)

I would greatly appreciate any advice/info you can provide!
 

Diane Kennedy

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Hi Carrie:

I would love to give you exciting tax ideas for this year, but there are a couple of things that need to happen first.

- In order to take any investment expense deductions, you will need to have investment income. (So, you need to actually start trading and making money)

- If you're going to do trading (short holds) as opposed to investments, then I'd definitely recommend that you do the mark-to-market election early next year. There have been some challenges with late filed elections. (ie...the IRS isn't approving them retroactive)

Good luck when you jump in there. I'm glad to see that you're taking the time to learn it all well.

Just curious have you read any of Van Tharp's books? I know him personally and his stuff really is brilliant. I've met a lot of people who follow his methodology for position sizing - it's work and you have to be very careful to not "fall in love" with any one position, but you can make real money doing it.

Diane
 
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Diane Kennedy

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Carrie:

just my opinion, but I suspect that the IRS will probably make it a little harder on Forex traders in the future. In the meantime, it's a pretty nice formula on how you report long-term and short-term gains. Still at issue, though, is how you take the deduction for other expenses like home office, education, etc... Those are still going to be limited.

Plus, if you have an AMT issue, getting long-term capital gains treatment doesn't matter.
 

CarrieW

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Thanks Diane!

im reading the link you provided now.

I am def not ready to trade this year. I wanted to know what i was getting myself into before i started next year. if I have gains I need to know how much i need to set aside for tax purposes becasue the money will need to come from somewhere to pay the tax bill. if i dont put it aside i may be blindsided come tax time.

im not worried so much about my deductions as i want to know exactly what to expect and how to handle things. I do have some educational expenses and I will obviously write off any and all that i legally can, i was more concerned with being prepared... I cant imagine at first id have THAT many deductions that it would make all that great of an impact.

i am going to do some more research on this mark to market thing youve mentioned... i read a thing or 2 on it yesterday and i have a few books on my wish list that deal with taxation for traders. Like i said tho im not just going to trust any old someone who claims they know whats best.(Im def not talking about you!) I want to know it for myself!

i guess one of my questions is whether or not to create an entity to trade thru(like a real business) or to do it as me and file elections for how its treated.

i think the thing that scares me is with it being soo active (more so then flipping is) that they would declare it a JOB and tax the crap out of me!

Is day trading income considered capital gains or what?

Like i said I am really interested in making this a long term profitable thing. ive done tons of research and this is my last big hurdle to figure out the tax impliations of it all... either way im not going to not do it I just want to be as prepared as possible!

you know what they say if you fail to plan you plan to fail! Im not planning on failing!
 

CarrieW

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I am reading van tharps trade your way to financial freedom. I believe I have some others from him in my reading list as well...(mostly its titles with no authors names in my list LOL)

I am very interested in proper money managment. Its going to be in my business plan!
 
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Diane Kennedy

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Thanks Diane!

i guess one of my questions is whether or not to create an entity to trade thru(like a real business) or to do it as me and file elections for how its treated.

i think the thing that scares me is with it being soo active (more so then flipping is) that they would declare it a JOB and tax the crap out of me!

Typically you use a business structure to protect assets or reduce self-employment tax. In this case, you might want to protect the wealth you're building from personal judgements, but you're not going to create additional risk because of trading. That's different from someone who might be opening up a local store - there is a lot of risk that puts personal assets at risk. In this case, I don't see a need unless you have a concern about the wealth you're creating (ie...when you start getting significant amounts built up)

If you make the mark-to-market election, you will get long-term capital gains treatment on assets held for more than one year + one day PLUS you get to claim a business on the rest so you can write off losses against other income and take your deductions.
 

CarrieW

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this was pointed out to me from a post on another board.

From Forbes.com article

http://www.forbes.com/home/2006/08/23/investools-forex-8reasons-in_wh_0823investools_inl.html

4) Tax Advantages: Currently, short-term capital gains are taxed at your current tax rate, and long-term capital gains are taxed at only 15%. Obviously, it is much better to pay less in taxes. In the Forex market, much to investors' delight, it doesn't matter if you take your profits one minute after you enter a trade, or one month after you enter a trade: the first 40 percent of your profits are taxed at short-term capital gains rates, and the remaining sixty percent is taxed at long-term capital gains rates.
???
whats short term cap gains tax?? (i thought all cap gains were 15% shows how much i know lol)when they figure out what your current tax rate is do they do it before you add in your trading gains or after? and by current tax rate im assuming they are talking about earned income tax rates...



I found this in reguards to mark to market in forex...

The year's net trading gains in each specific §988 transaction (FOREX) is usually taxed as a regular §1256 contract if you elected under §988(a)(1)(B) by the end of the day that the position was opened, pursuant to §988(c)(1)(B)(iii) I have no clue what this says LOL>


Im not as worried about my deductions from losses and expenses as I am in correctly figuring what real tax liability I should expect to have on my actual gains. (sure if i can deduct some things great if not oh well)

Im so confused LOL> whats this 40/60 split thing? what benifits if any would i get out of mark to market? any drawbacks to it? Ive only seen it discussed in reguards to trading and futures not specifically forex...

I am concerened about protecting the wealth I am creating. I want to be able to take the money out of forex and use it in other areas...

If I started an entitiy how would all this stuff change? im assuming its different for an individual rather then a business.

once you elect mark to market you cant change back. electing something I cant ever take back scares the crap out of me lol...

My head is swirling!

eta-i just read something about if you dont make regular withdraws from your account. even if you short term trade you can argue it as long term investing... Is this true?
 

CarrieW

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from http://answers.google.com/answers/threadview?id=470486

*Currency traders have additional unique and esoteric tax rules.
Currency traders are taxed like Commodities traders, except that
interbank currency traders must “elect out” of IRC section 988 to
benefit from the 60/40 tax treatment. For Currency tax law, you need
to learn about IRC Section 1256 contracts, Form 6781, special Form
6781 loss carry-backs and IRC Section 988 or alternatively, rely on
your qualified tax advisor.
Tax Tip: The Currency investor or trader will usually want to make
the election to enjoy the tax-beneficial treatment of IRC 1256 (60/40
tax treatment).

from what i understand you automatically get mark to market with this 1256. you dont have to elect it.

if you expect to have more then $3000 in losses then you do the 988 (instead of opt out)and you then can offset all your losses against any income. if you do the opt out your limited to $3000.

if you do the 988 it goes right into your 1040 form as ordinary gains and losses subject to regular taxes. if you do the 1256 as cash forex opted out of 988 then it goes to the schedule d form as capital gains and losses. then I belive the schedule d gets transferred to the 1040 but as cap gains or looses not oridinary.

still researching!
 
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CarrieW

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CarrieW

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Ok so I thought Id share the conclusions I have come to.

I am going to be opting out of the 988 and using the 60/40 split of the 1256(1256 automatically uses mtm for open positions on last trading day of the year without needing to file a seperate election) and getting trader tax status...if you file the seperate mtm election you cant use the 1256 you are forced to use 988.

mark to market takes capital gains and losses and converts them to oridinary income or losses(what your trying to avoid by opting out of the 988.)


if im correct in what ive read. that gives me the 60/40 split while allowing me to take as many expenses I incur as deductions(on schedule c) that results from doing business as a trader...if you dont qualify as a trader then your stuck with the $3000 limit on deductions and losses if you do the opt out...

as a trader(not elected to use mtm)you take the deductions on sch c but still claim gains and losses on the schedule d. therefore you claim no income on the schedule c. it can raise red flags at the irs but thats the correct way to file it becasue most businesses show income on the schedule c but for a trader its not possible.

still trying to figure out which would be better. as an indiviual tax payer or as a pass thru entity....

have i confused everyone yet LOL...any feedback??
 

Edge

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Typically you use a business structure to protect assets or reduce self-employment tax. In this case, you might want to protect the wealth you're building from personal judgements, but you're not going to create additional risk because of trading. That's different from someone who might be opening up a local store - there is a lot of risk that puts personal assets at risk. In this case, I don't see a need unless you have a concern about the wealth you're creating (ie...when you start getting significant amounts built up)

If you make the mark-to-market election, you will get long-term capital gains treatment on assets held for more than one year + one day PLUS you get to claim a business on the rest so you can write off losses against other income and take your deductions.

So for trader status, is a C-Corp and mark-to-market selection preferred? The main reason I want an entity is to start biz lines of credit to go to the next level.
 
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Diane Kennedy

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Actually two different things going on here:

mark-to-market, where applicable is a great election to make. One tricky thing right now with the IRS - they are not approving retroactive applications. So, if you're going to meet the qualifications for mark-to-market, make the election NOW for 2008.

C Corp - If you can't qualify as a mark-to-market trader, the C Corp may be a good choice. One of the issues with C Corp is that you dont' want to put long-term appreciating assets within a C Corp. So, as long as you are only doing short term trades, you'll be fine with the C Corp. But, if you go with a buy and hold strategy, you would wind up paying more in taxes.
 

Skiboy

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How does the IRS look at w-2 income if you have your trading business setup but still make a small amount from side gigs?

I get commission form selling insurance 1099, but still ski every now and then getting some w-2 income. I'm getting ready to setup my LLC but am unclear on this issue, otherwise I'll just stay on the investor side and not trader (mark-to-market).

Thanks in advance.
 

Pinnacle

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Has anybody checked out www.fairmark.com?

I just noticed it when I went hunting for information about the "mark-to-market" election Diane has talked about.
 
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