The Tax Consequence for Trading Stock

by Wilhelm Schnotz, studioD

About 54 percent of Americans held some form of stock as of April 2011, according to a Gallup poll. While many of these investors make long-term investments with little tax impact as they change in value, once you begin trading stock, the trades impact your taxes. The extent to which stock trades affect your taxes hinges upon how successfully you invested as well as the number of trades you made.

Capital Gains

Profits you earn from stock trades are income, but aren't taxed as if they're unearned income, such as dividends and interest payments. Instead, the Internal Revenue Service assesses capital gains taxes against these profits. If you hold the stock for a year or less, this is classified as a short-term gain, and the IRS taxes your gains at the same rate as your normal income. Long-term gains receive much more favorable treatment, and most investors pay a 15 percent tax on gains. For example, assume an investor purchases 100 shares of stock at $40 per share, for a $4,000 total purchase. If he sells it a year and a half later for $45 per share, raising $4,500, he's taxed at long-term rates on the $500, for a $75 tax on the trade.

Capital Losses

If there's any consolation in a losing stock investment, it's that the IRS allows you to claim capital losses in some cases. Capital losses aren't a direct deduction, however, and only serve to offset any capital gains you made during the year, so if you didn't profit from any investments through the year, they don't impact your taxes. You're also only allowed to claim $3,000 in losses each year. If the investor from the previous example also purchased a stock and sold it for a $300 total loss, his $500 gain is offset by the $300 loss, resulting in a $200 overall gain, or a $30 tax. You report all gains and losses Schedule D, and submit it with your 1040.

Traders vs. Investors

If you're an active trader, particularly a day trader, you may be able to classify your trades as a business entity of itself, and capitalize on business-related deductions. The IRS' definition of a full-time trader is murky, however, and is open to interpretation. If you don't have a full-time job, make at least a few trades a day -- and several hundred over the course of the year -- and specialize in short-term investments, you may qualify as a trader, rather than an investor.

Tax Benefits for Traders

If you believe you're active enough on the market to be considered a trader, you can treat your trading activities as if you are a sole proprietor. In this case, using Schedule C, you can claim deductions for a variety of business-related expenses, from fees and interest accrued through your trades, to home office deductions. You're also entitled to use "mark-to-market" accounting, which allows you an exemption from the $3,000 limit on losses. Essentially, using this system, you close the year as if you sold all your holdings on the market's final day of the year, tabulating gains and losses, and claiming them accordingly for that tax year. In reality, you maintain those holdings, but the maneuver allows you to claim more losses and begin a year with no unrealized gains on the books.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.

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