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Trader's Corner

Is Mark to Market the Only Route to Trader's Status?

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Last week's Trader's Corner article addressed some of the pros and cons of electing the mark-to-market accounting method for your trades. If you haven't had an opportunity to read that article, you might want to review it at this link before proceeding.

Is it necessary to elect the mark-to-market accounting method if you want to deduct trading-related expenses on your taxes? Some traders and experts believe that might be necessary. Others don't. Does electing the mark-to-market status automatically confer the right to deduct those expenses? Some traders and experts believe it does. Others don't.

Being able to deduct trading-related expenses such as charting programs, books, subscriptions and seminars depends on qualifying as a "Trader in Securities." It's possible that's a separate consideration from the election to use mark-to-market accounting methods. As I've stated in previous articles, I'm not a tax professional. This article is meant to present ideas that must be discussed and clarified with your own tax professional, not to give concrete advice. The question you should be asking that tax professional is whether it's necessary to elect the mark-to-market accounting method to be considered a "Trader in Securities." It may not be, but you must satisfy other, perhaps even more onerous conditions to qualify to qualify as a "Trader in Securities."

IRS Topic 429 sets forth no such requirement to elect the mark-to-market accounting method. In fact, the topic sheet says, "The tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under Section 475(f) to use the mark-to-market method of accounting." That doesn't seem to require that a trading business must elect that mark-to-market method of accounting, does it? Furthermore, the sheet goes on to say, "If the mark-to-market election was not made, then the gains and losses from sales of securities are treated as capital gains and losses that must be reported on Form 1040, Schedule D."

Being a trader in securities doesn't appear to require that mark-to-market election. Is the converse true, then, as some believe? Does electing the mark-to-market accounting method automatically confer status as a trader in securities running a trading business? It may not.

If a trader in securities can run a trading business using either accounting method, what is necessary to be considered a trader in securities? According to that same IRS Topic 429, a trader in securities must "seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation." While most day traders could honestly say their trading meets those conditions, the IRS specifies that it doesn't care if you call yourself a day trader or some other name. Further conditions must be met. "Your activity must be substantial, and [y]ou must carry on the activity with continuity and regularity."

The topic sheet continues, specifying the factors that should be considered when deciding whether you're a trader in securities who is conducting a trading business. Those factors include "[t]ypical holding periods for securities bought and sold," for example. In addition, the IRS wants you to consider how much time you devote to trading and the dollar amounts and frequency of your trades for the year. Another factor is "[t]he extent to which you pursue the activity to produce income for a livelihood."

Are you a retired person who engages in 30-40 trades a year? Are those trades condors that require maintenance of about $80,000-$150,000 a month and produce about $6,000 a month in income, upon which you depend to pay your bills? Are you monitoring those trades every day, listening to webinars and attending seminars to hone your skills? Or are you a thirty-something with an executive job at a Fortune 500 company, pulling a few hundred grand a year in salary, who fires off two or three QQQQ scalps a week between meetings? Are you bringing in a few hundred dollars here and there, trading on your gut feeling? The second trader might trade more frequently than the first, but which is most likely to meet the IRS's requirements?

I'd like to find the person who wrote IRS Topic 429 and give that person a pat on the back. That sheet proved the most accessible of any of the many IRS publications I researched when writing this series of articles. However, clarifications don't stop with the sheet itself but have been nailed down through many engagements with the IRS. How much documentation must a trader keep to prove that substantial time has been devoted to developing trades? Is it necessary to keep a daily trading log? Is the fact that trading condors requires less moment-by-moment monitoring than day trades offset by the sometimes greater maintenance requirements? Does it help that condors are considered one of a number of income-producing rather than speculative trades?

Discuss your particular situation with your tax professional or begin your own research on this topic with IRS Topic 429. This series of articles has pinpointed a number of issues to be researched or discussed with your tax professional. As traders, we don't want to get on the wrong side of the market action, and as taxpayers, we don't want to get on the wrong side of the IRS, either.

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