EDUCATION CENTER
IN THE MEDIA: STAR-LEDGER
"Tax rules vary, depending on the trader"
By Sam Ali, Star-Ledger Staff
March 5, 2000
So, you consider yourself an active stock trader?
Well, win, lose or draw, you're day of reckoning with the taxman is fast
approaching. So it's
probably a good idea to know what you're up against. Depending on the
type of trader you are, how much you make or lose, and how long you hold
your investments, different rules apply.
For day traders, all that high-octane turbo trading you did in 1999 may
come back to haunt you on April 17, regardless of how well or not so well
you did. And average investors who bought and sold only a few stocks here
and there in a short period of time can also get soundly clobbered when
tax time rolls around if they didn't plan things properly with one eye
squarely focused on Uncle Sam.
Here then are a few pointers to help keep your investments from turning
into a tax nightmare.
Timing is everything. While all stock profits are considered capital gains,
only those stocks you
have held for more than one year qualify for preferential long-term capital
gains treatment.
What does that mean?
Well, the higher your tax rate, the more money you can save by holding
your stocks longer
than 12 months. Specifically, 12 months and a day. Longer-term gains are
taxed at 20 percent
for anyone in the 28 percent or higher tax bracket. If you're in the 15
percent bracket, your
gains are taxed at only 10 percent.
Any investor who holds onto their stocks for 12 months or less is taxed
at their ordinary
federal income tax rate, which could be as high as 39.6 percent. Take
the case of $1,000 in
capital gains. A person in the maximum 39.6 percent tax bracket who sells
his before 12 months is up will be forced to fork over $390 in taxes,
for a net gain of $610.
That same person will pay only $200 in taxes for a net gain of $800 if he sold the stock after 12 months and one day.
''When you're contemplating selling a stock, you really have to think
twice if it makes sense
to sell it," said Peter J. Beckwermert, a CPA at Mirsky & Co.,
a Wayne-based accounting firm.
"A lot of people don't give a lot of thought to what the tax impact
might be."
Don't overstate your gains.
If you sold securities at a loss, you can use them to offset your gains. If your losses exceed your gains, you can deduct the loss against ordinary income up to $3,000 a year, said Beckwermert. Accountants suggest that investors in high tax brackets try to incur capital losses in years when they have a lot of long- term gains, because the loss is more valuable if it's used to offset income.
Also, investors who sell securities need to calculate their gains and losses carefully to minimize tax bills. For example, let's say you invested $10,000 in a mutual fund 10 years ago. Today, the fund is worth $20,000. Does that mean you owe taxes on $10,000 in capital gains if you sell your shares? Not necessarily. If $8,000 comes from reinvested dividends and capital gains on which taxes have already been paid, your actual gain for tax purposes is really only $2,000 - $10,000 minus $8,000. Many people overstate their gain and the taxes owed, said Beckwermert.
Keep track of your trades.
Keeping good records is vital for all investors. Yes, at the end of every year, your brokerage will send you a 1099 listing all the sales you made over the past year. The problem is the 1099 doesn't really keep track of all the dates and dollar amounts of all your purchases. That's up to you.
And your job will become infinitely easier if you take advantage of personal finance software, such as Intuit's Quicken or Microsoft's Money, which automatically keeps track of how much you paid for each of your shares and lets you decide which shares you want to sell.
A large number of brokerages, including DLJ Direct, E*Trade, Datek and
Charles Schwab, allow
you to download your transactions from their Web sites. This is less time-consuming
than
typing all your trades into the program by hand or keeping all your transaction
records in a
shoebox. And best of all, come tax season, you can directly feed this
information into a good
tax preparation software such as Intuit's Turbo Tax or Kiplinger's Taxcut,
which does a
decent job of sorting out long- and short-term gains for you.
Decide what kind of trader you are and plan accordingly.
Are you an active short-term investor? A day trader? A disciplined long-term investor?
It really pays to know the difference:
Taxwise, short-term active investors have it the worst. When they win,
they must pay taxes on
all gains that year with no ceiling - at the higher short-term capital
gains rate.
And when they lose, they're only allowed to deduct $3,000 per year in
net losses. In other
words, if you're out $6,000 on a few bad trades, you can only deduct $3,000
in one year, and
dutifully carry the rest over for the following year.
As for long-term investors, Congress, through the tax code, has long
provided incentives -
such as favorable long-term capital gains rates - to investors who build
wealth by leaving
their money in stocks for the long haul. But even those investors are
still bound by the
$3,000 limit on their capital losses.
For day traders - that hyperactive subset of traders who make dozens of trades a day, everyday - the tax laws are on your side, said Robert A. Green, founder of GreenTraderTax.com, a company that specializes in tax problems faced by day traders.
In 1997, under the Taxpayer Relief Act of 1997, day traders gained the
right to deduct 100
percent of their losses (using mark-to-market accounting rules) and 100
percent of their
expenses, including margins, such as interest fees, the cost of their
computers and software,
tax advice and educational expenses as ordinary losses (using a Schedule
C.)
In order to reap these benefits, however, day traders must plan carefully for their tax future.
To qualify as a day trader, an investor must notify the IRS by April 15 of a given tax year that they intend to use mark-to-market accounting rules.
(Time is up for this tax season, but anyone interested in using mark-to-market
accounting for
the 2000 tax season should elect to do so by April 17, 2000.)
As for Schedule C, anybody can use the form without a special election,
provided they fit the
profile of an active day trader, Green said.
A mark-to-market trader is:
not subject to the $3,000 capital loss limitation that applies to the
net Schedule D loss for
regular investors.
not subject to self-employment taxation.
not subject to the Wash Sale Rules (see explanation below).
Green says that many investors and accountants are unaware that Congress
gave day traders
business deductions in 1997.
''If a day trader loses $50,000, he can deduct $50,000, if he elects mark-to-market accounting, and he can use a Schedule C form to deduct all trading expenses and margin interest," Green said.
Generally, the IRS will consider you a day trader if the only way you
earn income is to trade
stocks every day from your own personal account, and if you hold your
positions for a very
short period of time.
Although the IRS has not defined the number of trades per year an investor
must make to
qualify as an active trader or a day trader, accountants say traders should
have at least one
to two trades under their belt per day to keep the IRS happy.
All washed up
People who frequently trade in and out of stocks are often at risk of
running up against the Wash Sale Rule. Basically, the rule says that if
you sell a stock at a loss and then buy the same stock back within 30
days, you don't get to take the loss on your taxes. (Normally, long-term
losses can be used to help offset your capital gains.)
Your best bet: If you're an active trader,
don't buy back a stock you have just sold within a
30-day period.
One caveat: Day traders who elect mark-to-market
accounting status and use a Schedule C are
not bound by wash sale rules.
A note on mutual funds
The IRS has created a new shortcut that allows many mutual fund investors
to avoid the hassle
of filling out the dreaded Schedule D. If you received only capital gains
distributions from
your mutual funds but you had no other capital gains or losses to report,
you may be able to
skip Schedule D. (Yahoo!)
In its place, you can fill out a much shorter worksheet and report your
fund distributions on
the front of Form 1040. But before skirting Schedule D, however, read
the IRS instructions
carefully to make sure you qualify for the shortcut.
Sam Ali
Business Writer
THE STAR-LEDGER
Newark, NJ 07102
phone: (973) 877-4188
fax: (973) 642-1594
e-mail address: sali@starledger.com