Holding periods and gain/loss characterizations
Long-term
gains are defined as securities held for more than a year. Short-term
gains are defined as securities held a year or less. Since short-term
gains are taxed at your income rate (possibly as high as 35%) and
long-term gains are taxed at a fixed 20%, it is tax efficient to sell for
a gain after you have held a stock for more than a year (long-term) and
sell for a loss when you have held a stock for a year or less
(short-term). Smart investors will try to offset all short-term gains with
short-term losses before year's end. In addition, after you offset all
your capital gains, you can use any remaining losses to offset as much as
$3,000 in ordinary income.
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Annual $3,000 capital loss limit
If
you have a net loss position, the IRS allows you to write off $3,000 per
tax year. If you have net losses greater than $3,000 you can carry those
additional losses forward to subsequent tax years.
Complete the Capital Loss Carryover Worksheet in the Schedule D to
determine what portion you are carrying forward. Utilizing the $3,000 capital
loss write off can result in substantial savings for taxpayers.
Married
couples are only allowed to write off a total of $3,000. The annual limit
for married couples filing separately is $1,500 each. This is a true
marriage penalty.
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Wash Sales
The
IRS created the Wash Sales rule to prevent tax-payers from realizing
losses for tax purposes and then buying back into the same security.
You cannot deduct losses from securities if you re-purchase that
security either 30 days before or after you sell it for a loss. If you do
re-purchase the security within the 61-day window, the loss is deferred.
The loss is added to the cost basis of the replacement shares purchased,
and the holding period of the replacement shares includes the holding
period of the original shares sold.
Confused yet? Let's say you
sold 100 shares of Amazon for a $3,000 loss and then re-purchased 100
shares, within 30 days, for $5,000. Because of the wash sale, you are not
allowed to report the $3,000 loss on your Schedule D and the cost basis of
the new lot becomes $8,000. GainsKeeper will adjust all wash sales
automatically so you do not have to.
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New 5 year Super Long Term tax rate
Another complication in
long-term taxation arrives January 1, 2001. As of this date (unless
Congress changes their mind), lower rates come into effect for gains
having a holding period of over 60 months (called the
"ultra-long-term rate" here). The rates are 8% if you are in the
15% bracket, 18% otherwise.
If you are not in the 15% tax bracket, the new tax rate will be in effect
for those securities purchased after 1/1/2001, meaning the earliest the new rate
will effect you is 1/1/2006. For securities purchased before 1/1/2001, you
can make an election to recognize gains on these securities and
you can mark the asset to market at its fair market value on
1/1/2001. You will have to declare as income and pay tax on any unrealized
gain (and presumably get to deduct any unrealized loss) on the asset. The
holding period clock will also reset. (This is the same as selling and
repurchasing the asset without actually doing so. It is currently unclear
if wash sale rules will apply to loss property marked to market).
There is yet
another twist to this exception -- if you are in the 15% bracket, the 8%
rate is available to you as of 1/1/01, even if you did not acquire the
asset before 1/1/01. In any case, we strongly advise researching the issue
and talking to a tax professional before doing something that is subject
to this rule. As you can
see, the ordinary income and short-term rate
is over 100% higher (35% vs. 18%) than the ultra-long-term rate and
close to 100% higher than the long-term rate. The long/short term
distinction is something to keep in mind if you are considering selling at a gain
and are getting close to one of the holding period boundaries.
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Are you an Investor or a Trader?
If you meet the IRS's definition of a
"Trader", you can save big bucks come tax time. According to the
tax law, "Traders" are in the business of buying and selling
securities. ----- Not so fast! I know what you are thinking. "I'm a
trader". Shoot, you probably flipped three stocks last week for over
a $6,000 gain. Unfortunately, even if you have two online accounts and you
place a few trades a week, the IRS still considers you an
"Investor."
How to Qualify as a
"Trader"
To determine if you
qualify as a "Trader" versus an "Investor", we can
only follow the guidelines determined by several court cases addressing
this issue.
SmartMoney, July
1999 states, "The court says you are a trader if:
- You spend lots
of time trading (more than 20 hours a week). Preferably, you don't
have a regular full-time job.
- You have
established a regular and continuous pattern of making lots of trades.
Probably multiple buys and sells for every day the market is open.
Vacations are understandable, but lapses of weeks or months without
any trading activity will immediately move you from "Trader"
to "Investor" status.
- Your goal is
to profit from short-term market swings rather than from long-term
gains or dividend income. What is profiting from short-term market
swings? Getting in and out of a position on the same day or within a
week. Holding stocks for a month or two blows any chance of claiming
trader status.
- You don't use
the Small Order Execution System (SOES) for your trades. Only amateur
investors are allowed to use SOES, by using SOES you would be telling
the SEC you are an amateur while trying to tell the IRS you are a pro
trader.
- Satisfy the
above requirements for an unbroken string of at least six months.
Benefits
of "Trader" Status
- Deduct all
your investing expenses on Schedule C, like any other sole proprietor.
This eliminates the need to claim these expenses on Schedule A and
eliminates the limitation of only writing off the amount that exceeds
2% of your gross income. Furthermore, Schedule C write-offs reduce
your adjusted gross income, which makes it more likely that you can
fully deduct all your personal exemptions.
- Deduct your
margin account interest on Schedule C.
- Write-off up
to $19,000 a year for equipment used in your trading activities
(computers, magazines, Bloomberg, fax machines, office material) under
Section 179.
- Exempt
yourself from all wash-sale rules (See Wash-Sales for more info.)
- Deduct an
unlimited amount of losses versus the investor's limit of $3,000 in
capital losses."
Is
it possible to qualify as both a "Trader" and an
"Investor?"
Sure is! The trick
is to handle your "Trader" investments differently than your
"Investor" investments. In order to treat investments
differently, you must separate your long-term holdings (Investor Status)
from short-term holdings (Trader Status) by identifying them as such in
your records on the day you buy the holding. It would help your claim as
both Trader and Investor status if you actually created a separate
account. That is, a trader account and an investor account.
Please consult your
tax advisor for details on filing Schedule D and C under
"Trader" status and the IRS Revenue Procedure 99-17 at the IRS
website, or goto Tax
Forms to download the latest IRS tax forms. The information
provided above is intended as a preliminary status check, not the bible in
Tax Law.
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Presentation Matters
One
final note to remember when filing your 2000 tax return: be sure to
provide accurate backup documentation of your trading records.
This will appease the IRS and minimize the chances of an audit on
your return. If you have a GainsKeeper
account, your Realized Gain/Loss report will provide this level of detail
for filing purposes. Also, be
sure to include backup confirmations from your broker on all specific lot
transactions with your tax return. Rule
of thumb, if you can't figure out your own report, chances are the IRS
won't either. The last
thing you want is a mandatory appointment with an IRS agent next summer to
decipher your records.
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