Tax Implications of Day Trading

tax day trading

The global pandemic brought a significant rise in amateur day trading. These newbies, with their smartphones and Robinhood apps, buy and sell shares of stock to their heart’s content with the promise of cash flow and without the worry of commissions. However, those interested in embarking in frequent day trading must be aware of the tax implications that may either be beneficial or detrimental.

Day Trading vs Investing
While its popularity has risen in recent years, day trading is far from a new venture. Technological advances have simply made it more accessible to the layperson. A day trader purchases shares of stock early in the day when the market opens with hopes of substantial price appreciation prior to selling before the stock market closes. Sounds simple enough, right?

The stocks traded and the times they are bought and sold are not chosen by day traders at random. Much time is put into perusing over charts and data in order to make the very best educated guess possible for the highest return. In fact, some traders pour so much time and effort into day trading that it becomes their full-time job.

While day trading and investing both involve the buying and selling of stock, they are markedly different. The research behind day trading focuses more on technical analysis. Charts and graphs are studied in order to find movement patterns in stock prices. Investing relies more on fundamental analysis, which involves studying the numbers as well as the ongoing efforts and value of the underlying business.

Short Time, High Tax
Investing has been historically viewed as a long-term activity by both the general public and, more importantly, the Internal Revenue Service. When these taxpayers decide to sell their stock, they realize long-term capital gains. These gains are taxed at long-term capital gains tax rates of 0%, 15%, and 20%, dependent upon filing status and taxable income.

For those taxpayers who choose to follow the day trading path, Uncle Sam will want a larger slice of their pie. Because day trading involves holding periods of less than a year, or more accurately less than day, taxpayers that use this income-producing activity miss out on those long-term capital gains tax rates. Those short-term capital gains are instead taxed as ordinary income. Furthermore, taxpayers who are day traders and have taxable income above $250,000 if married filing jointly, $125,000 if married filing separately, or $200,000 if filing single, will also owe a net investment income tax of 3.8%.

Mark to Market
For taxpayers looking to pursue day trading as a full-time career, the IRS is looking out for you. The section 475 “Mark to Market” accounting method election allows taxpayers who are day trading consideration as a trade or business. While any taxpayer can make the election, it is not guaranteed. The IRS will consider the taxpayer an investor unless the taxpayer can prove themselves to be a day trader. That proof lies in the consistency and regularity of your trading.

While the IRS, Tax Court, and U.S. Department of the Treasury have not established set minimums and maximums regarding the volume of trading needed to qualify as a day trader, the Tax Court case history does provide a baseline of sorts. In William F. Poppe, T.C. Memo 2015-205, Mr. Poppe informed the Tax Court that he made roughly 720 trades per year and dedicated around four to five hours a day engaged in trading related activities. The Tax Court found Mr. Poppe’s trading to be “sufficiently frequent, regular, and continuous to constitute a trade or a business.”

If a taxpayer is granted the Section 475 election, it comes with the benefit of providing an exemption to wash sales (the inability to use a loss from a stock sale because a “substantially similar” stock purchase was made within 30 days before or after the sale that resulted in the loss). The taxpayer may also be able to take advantage of the capital loss carryover of losses exceeding $3,000 for the tax year and gain eligibility for the qualified business income deduction and other business expense deductions.

No Election, No Problem
For taxpayers who choose not to take the Section 475 election, or had their election denied by the IRS, all is not lost. Maneuvering trades strategically can help day trading taxpayers prepare for tax season. They must be mindful of wash sales in order to take advantage of losses when available. Day trading taxpayers must be prepared to pay quarterly estimated taxes if the trades for the year have been particularly good. Finally, day trading taxpayers must be aware of their tax rate.

While the prospects of being in the business of trading stocks may be lucrative, only proper tax planning can ensure day trading taxpayers keep the bulk of their profits. Learning the ins and outs of technical analysis can lead to more wins than losses. However, knowing the relationship between day trading and taxes will make a taxpayer better equipped to play the game.