Day traders possess a great deal of skill and also rely on luck to make solid investment income. When starting a trading business, part of the investment strategy must include managing taxes.
There are specific IRS requirements that traders must follow. Losing a large portion of your gains can happen without a good plan.
Generally speaking, investors pay taxes on the profits that they make. Day trading taxes can be much higher.
So, how is day trading taxed? Let’s dive in!
What is Day Trading?
Day trading is the buying and selling of securities such as stocks that occur once or more on the same day. The goal of day traders is to buy an asset, keep it for a short time, and sell it for a profit when the price increases in the short term.
It’s possible to make a profit on the same day by purchasing the investment at a low price and selling it for more later in the day.
There are many risks involved with day trading. For example, you may speculate whether the price of an investment will change. Day traders typically closely monitor the news and markets.
A riskier strategy that some traders use is buying on margin. That means you’re borrowing money to buy securities hoping your risk will pay off.
How is Day Trading Taxed?
Investors must typically pay taxes on any earnings from their investments. Day trading involves owning assets for a short time which are called capital assets. You must pay taxes on the difference between what you paid for the investment (or its adjusted value) and how much it was sold.
Capital gains taxes are the taxes that are paid on profits from the sale of these capital assets. There are two types of capital gains taxes explained below:
Short-Term Capital Gains Taxes
Short-term capital gains refer to the tax rate applied to assets taxed as ordinary income. The holding period for these capital gains is less than a year.
As your income grows from the profit you make from day trading, the possibility of moving into a higher tax bracket also exists. The higher you move up in the tax bracket, the higher your tax rate is.
Long-Term Capital Gains Taxes
Long-term capital gains refer to the tax rate that’s applied to assets that have been held for more than a year. The tax rates on these earnings are more favorable to traders.
Difference between Long-Term and Short-Term Taxes
To put these two types of capital gains taxes into perspective, let’s consider an example. Your return is taxed anywhere between 10-35% or more (dependent on how much you’ve made through the year) on short-term capital gains.
Long-term capital gains are taxed anywhere between 0-20%, depending on income thresholds.
If you are single and made between $95,367 to $182,100 in short-term capital gains, you would be taxed at 24% in 2023. Under short-term capital gains, with the same filing status, the income threshold would fall between $44,626 to $492,300 and be taxed at 15%.
How Day Traders Can Reduce Taxes
Traders will most certainly want to minimize the amount of taxes they must pay on income earned from these gains. If you’re getting into day trading, it’s best to talk to a tax professional or CPA to discuss your situation.
Here are a couple of strategies to discuss with a professional to determine if they may work for you:
Deduct your Trading Expenses
You might be able to deduct investment expenses as trading business expenses if you’re classified as an active trader who makes money from market movements. Other types of deductions that aren’t typically available to taxpayers are possible and can lower taxes you owe.
Your internet service, home office, office supplies, and subscriptions are among the deductions you may qualify for. Interest expenses from margin loans may also be deducted.
Use the Mark to Market Accounting Method
Investors typically offset capital gains with capital losses. That means if you make a profit on one trade and lose on another, you can lower your taxable income.
The caveat to this is that you’re allowed to deduct up to $3,000 in excess losses from your income.
The mark-to-market election allows you to take advantage of some additional benefits. If you qualify as a trader, you can take a deduction for losses from your income above this $3,000 limit.
Another benefit is that at the end of the tax year, you get a fresh start because all your gains and losses reset to $0. The Section 475 mark-to-market election must be filled out by the tax filing deadline for the previous year.
You must qualify as a trader as well. The IRS defines a trader as an individual who seeks to profit from everyday market moves and regularly engages in substantial trading activity.
Using certain tax-advantaged accounts, traders can grow money tax-free and completely avoid paying capital gains taxes. An IRA is an example of an investment vehicle in that investors can contribute pre-tax dollars for a retirement account.
You’ll be taxed at the ordinary income tax rate when you withdraw money from the account after retirement by deferring taxes on gains.
One thing that investors should watch out for are the risks of day trading with an IRA. For example, you could be classified as a “pattern day trader” if you trade too often. That could lead to being required to keep at least $25,00 in your account.
Standard margin accounts are also not available in IRAs. Many day traders use margin accounts to borrow money that’s used to make new trades.
Use the Wash-Sale Rule Exemption
Harvesting tax losses is a strategy that many investors use to lower their tax liability. This method involves selling losing investments in the year that they make gains. The investment income that they must pay taxes on is lowered.
The “wash sale rule” is an IRS regulation that prevents you from deducting capital losses if you sell at a loss and buy the investment back before and after 30 days of the sale. The purpose of this rule is to prevent investors from benefiting from a tax deduction by creating an investment loss.
However, even if you’re not trying to game the system, the wash sale rule could negatively impact you. For example, if you sell shares from a non-retirement account and purchase the same shares into an IRA within 30 days, tax losses for the sale can’t be claimed.
Being classified as a trader will exempt you from this rule. You must use the mark-to-market accounting method to qualify.
Day Trading Taxes — How to File
The main distinction in tax structure is long and short-term investments. Long term investments are held for a year or more, while short-term investments are held for less than a year.
For accounting and tax purposes, it’s best to have a separate account for day-trading and long-term investing.
The gains and losses must be reported on form 8949 and Schedule D. Up to $3,000 can be deducted per year as net capital losses. Married couples must file separately and the limit for each individual is $1,500.
To claim losses, trades must have receipts on these trades. The wash sale rule limits you from holding that stock for 30 days before and after the holding period to claim them at tax time.
Expenses and zero income are reported on Schedule D. Trading profits are provided on Schedule D. Losses over $3,000 are carried forward as a loss and can’t be claimed.
Tips for Traders
If you’ve decided to get into day trading, here are some suggestions below that can help you navigate the tax implications.
Keep Track of Purchases and Sales
Whether you are buying or selling securities, it’s important to keep up-to-date records. Many trading platforms will keep track of your trading activities.
But at the end of the day, you’re responsible for paying the correct amount of taxes. Since you can reduce your tax liability by using your losses to offset gains, you should carefully track your sales and purchases.
Stash Away Part of Your Proceeds from Sales that Have Gains
Saving part of your sales proceeds can help ensure that you’re funded to pay your income tax liabilities for the year. Money isn’t automatically deducted like it is for a traditional paycheck for paying taxes. This habit will ensure that you’re ready to cut a check when you owe taxes.
Time your Sales Carefully
Holding a stock for a day over one year can significantly affect your liabilities for the tax year. Slowing down or accelerating gains near the end of the year can also have big tax consequences.
For example, let’s say your trading gains were $20,000. If you still own some shares of that stock that would result in a loss of $10,000 if you sold them, you may be better off selling them this year. The reason is that it would reduce taxes for your current year while taking the deduction next year might be limited if you don’t have gains next year.
Compliance with the IRS
Ultimately the most important thing that you can do is comply with IRA regulations. Your gross sales proceeds are being tracked by the IRS. If there are differences between your income and the income stated on your tax documents, you could potentially trigger an audit.
Talk to a CPA
Consider consulting with a CPA before getting too far into the journey of becoming a day trader. A CPA can help you understand the tax implications that could arise.