The average American taxpayer is not aware that people who officially qualify as running a trading business receive special tax treatment. Their income comes from the profit they make by trading options, equities and other asset classes, and is viewed as “investment” income. Investment income is taxed differently than salary and wages, which are considered “earned” income.
There are significant differences between the way that investment income and earned income are taxed and how the two can be combined. Let’s take a closer look at what being considered a trader entails, and what its impact could be.
The Requirements for Being Considered a “Trader”
The Internal Revenue Service defines a “trader” as a person in the business of buying and selling securities for their own account. The criteria for this classification include:
Similarly, traders’ contracts qualify for Section 1256 treatment, avoiding wash sales rules that apply to investors. For an investor, securities that are sold at a loss and then bought again within a 61-day window measured as being 30 days before or after the closing transaction cannot be recorded as a loss. Instead, it is measured based on the cost basis of the shares that you repurchase, and the loss can’t be taken until those newer shares are finally liquidated, at some point in the future. Everything gets adjusted, thus disallowing the original loss, and this is true even if you are using two different brokerage accounts. You can’t avoid the wash sales rules by selling for a loss in one account and buying back using another. As a qualified trader, however, wash sale rules don’t apply. Gains are carried over to Schedule D, while losses can be used to offset gains for previous years or for the current year.
Those who trade options are able to take advantage of several different protective tax strategies. These include:
Offsetting Gains by Purchasing Put Options
The short-term tax consequences that come from having substantial gains on large stock positions can be offset by buying stock puts. But you need to remember that if the stock price continues to rise, you run the risk of losing your money when the put expires. By choosing an OTM – or out of the money – Put, you could lose the entire premium as well as the cost of the transaction. The longer the option, the greater the “theta” meter of loss. A better, safer option might be to choose in-the-money options, which retain some of their intrinsic value – though they can still end up expiring with no value.
To help with theta risk, consider buying in-the-money options, because they’ll have some intrinsic value and not all “time” value, initially. Of course, they can still expire worthless if they’re OTM at expiration, but the risks are lower.
LEAPS®
Another possibility is to get a tax advantage by trading option contracts that expire far in the future. Known as LEAPS, or Long-term Equity AnticiPation Securities, these have expiration dates as far in the future as 32 months. The length of time that you hold them will determine their tax treatment, but there are clear advantages compared to what is offered by buying and selling the more traditional short-term alternatives. The fact that LEAPS can be held for more than a year means that profits can be treated and taxed as a long-term gain and offer a great way to diversify your portfolio.
IRA Trading
You can trade an Individual Retirement Account (IRA) or any self-directed retirement account and realize significant tax benefits in some cases. The key is to do your research into what your brokerage allows, as some allow options in IRAS and others do not. If you can use this strategy, you will find that the wash sale rules essentially don’t apply because you will only be taxed when a distribution is made. If the account is taxable, however, it may trigger a wash sale.
Hedging through Index Options
You can realize preferential tax treatment through options on the Nasdaq-100 (NDX), the S&P 500 Index (SPX), and other broad indices — as well as futures contracts — if you do so using Section 1256 contracts.
Traders and investors alike can realize significant savings by consulting with a tax professional who can help them navigate the complexities of short- and long-term gains. For assistance from an experienced tax advisor, contact us today.
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