In order to properly determine the correct treatment income and expenses, it is first necessary to classify the type of investment activity occurring.
An Investor buys and sells securities solely for their own account. They are not engaged in a trade or business. An investor's investment expenses are taken as miscellaneous itemized deductions on Form 1040, Schedule A (PDF), subject to the 2% AGI limitations (with the exception of investment interest which is not a miscellaneous deduction but subject to its own special limitations). An investor's sale of securities results in capital gains and losses.
A Dealer in securities has inventories of securities that they hold for sale to customers in the ordinary course of their trade or business. Their business expenses are deductible as ordinary business expenses. A dealer doing business as a sole proprietor would deduct their expenses on Form 1040, Schedule C (PDF). A Dealer's sale of securities is reported as ordinary income.
A third classification is Trade. A Trader is in the trade or business of buying and selling securities for their own account. You are a trader in securities if you meet all of the following conditions:
You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation. Your activity must be substantial. You must carry on the activity with continuity and regularity. The following facts and circumstances should be considered in determining if your activity is a securities trading business:
Typical holding periods for securities bought and sold. The frequency and dollar amount of your trades during the year. The extent to which you pursue the activity to produce income for a livelihood The amount of time you devote to the activity. A trader's business expense are reported on Form 1040, Schedule C (PDF), not as itemized deductions on Form 1040 Schedule A. The deductions are not subject to the limitations that apply to Schedule A (2% AGI limitation and special limits on investment interest). A trader gain or loss on sale of securities is reported as capital gain or loss on Form 1040, Schedule D (PDF) unless they have made the mark-to-market election.
If a trader has made a mark-to-market election, gains and losses are reported on Part II of Form 4797 (PDF) as ordinary income. For information regarding the manner and timing of making the mark-to-market election, see Chapter 4 of Publication 550, Investment Income and Expense or Revenue Procedure 99-17, 1999-1 CB 503.
The proper classification of your investment activities is important to determine how income and expenses are to be reported. Investors trade solely for their own account and do not carry on a trade or business. Their securities sales result in capital gain or loss and their deductible expenses are itemized deductions. Dealers sell securities to customers in the ordinary course of trade or business. Their sales result in ordinary gain or loss and their deductible expenses are trade or business expenses. Traders buy and sell securities frequently but have no customers. Their purchases and sales result in capital gain and loss, and their deductible expenses are trade or business expenses.
Even if you engage in extensive securities activities, you are an investor, not a dealer or trader, if you do not seek profit primarily in swings in daily market movements, and do not personally engage in or direct the purchases or sales. An investor trades for profit-motivated reasons such as long-term appreciation, dividends and interest. Whether the activities of an individual constitute trade or business or investment is determined from the facts in each case. These distinctions have been established through court cases.
If your trading activity is a business, your trading expenses would be reported on Form 1040, Schedule C (PDF), Profit or Loss from Business (Sole Proprietorship), instead of Form 1040, Schedule A (PDF), Itemized Deductions. Your gains or losses, however, would be reported on Form 1040, Schedule D (PDF), Capital Gains and Losses, unless you file an election to change your method of accounting.
If your trading activity is a business and you elect to change to the mark-to-market method of accounting, you would report both your gains or losses on Part II of Form 4797 (PDF), Sales of Business Property.
A change in your method of accounting requires the consent of the Commissioner and cannot be revoked without the consent of the Secretary. Though there is no publication specific to day traders, the details for traders in securities and commodities are covered in Internal Revenue Code Section 475 (f) and Revenue Procedure 99-17.
References:
Publication 535, Business Expenses Form 3115 (PDF), Application for Change in Accounting Method Source: www.irs.gov
