In my previous article about end of year tax selling, I made a point of saying that I am not a tax professional, so before you act on any of my advice, please consult an expert.

There is a little know classification -- affectionately known as "traders status" -- which you can elect to take with the IRS.  It has a number of advantages from a tax standpoint, but, it also significantly raises your chances of getting audited, so you have to think long and hard before taking it, making sure you fit all the requirements.


First though, let's look at the advantages.

For normal investors, on December 31st, your gains and losses are only based upon positions you have closed out.  But with a traders status you are able to use the "marked-to-market" formula instead.  This means that you don't actually have to sell a position to realize its loss; instead, you just take the closing price at the end of the year and use that against your cost basis.  That same price then become the new cost basis for the stock in the following year.

With traders status, you are essentially classifying your stock market activities as a business, and as with all businesses, you are allowed to wash ALL of your losses against your gains.  This means you are no longer limited to reporting just $3,000 in capital losses on your tax return.

As a business you are also allowed to write off expenses that investors can't.  The cost of your software, investment subscriptions, even industry events, can be written off as expenses for your trading activities.

But as they say, what’s the rub?

First off, you have to elect to take the traders status before the beginning of the New Year.  You can't just get in to October of the year and decide to take the election.  But the bigger issue is the criteria needed to qualify for the status.

Let me be clear here; anybody can elect the status, the question is, will it hold up if you are ever audited by the IRS?

The IRS is purposely vague about what criteria legally will justify the traders status but there are some general guidelines you should adhere to.

You need to trade every day, and multiple times a day.  The more times the better.  Even an investor who trades 3-4 days a week may not qualify for the status.  And ideally, trading should -- by far -- make up the vast majority of your income.  Meaning, if you make $50,000 a year trading, but earn $100,000 a year as a copier salesman, chances are the traders status will not hold up in tax court.

As with most tax issues, the IRS did not just fall off a turnip truck yesterday.  They understand the benefits that the traders status brings, and how tempting it is for the average retail trader to try and fudge their way into electing it.  So the bottom line is, if you are really not full time trader, actively engaging in the market on a daily basis, and deriving the lion's share of your income from that activity, it is best to stick to your normal investor status.

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