This topic explains if an individual who buys and sells securities qualifies as a trader in securities for tax purposes and how traders must report the income and expenses resulting from the trading business. The term security is defined in Internal Revenue Code section 475(c)(2). In general, the term security includes a share of stock, beneficial ownership interests in certain partnerships and trusts, evidence of indebtedness, and certain notional principal contracts, as well as evidence of an interest in, or a derivative financial instrument in, any of these items and certain identified hedges of these items. Please refer to section 475(c)(2) for a complete list of items that qualify as a security. To better understand the special rules that apply to traders in securities, it is helpful to review the meaning of the terms investor, dealer, and trader, and the different manner in which they report the income and expenses relating to their activities.
Investors typically buy and sell securities and expect income from dividends, interest, or capital appreciation. They buy and sell these securities and hold them for personal investment; they are not conducting a trade or business. Most investors are individuals. Sales of these securities result in capital gains and losses that must be reported on Form 1040, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. Investors are subject to the capital loss limitations described in section 1211(b), in addition to the section 1091 wash sales rules. Investors may be able to benefit from a deduction for the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. They report these expenses on Form 1040, Schedule A (PDF), Itemized Deductions, as miscellaneous deductions allowable to the extent that they exceed 2% of adjusted gross income. They can also deduct interest paid for money to buy or carry investment property that produces taxable income on Schedule A, but under section 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. Review Topic 703, Basis of Assets for additional information. Investment income is not subject to self-employment tax. For more information on investors, refer to Publication 550, Investment Income and Expenses.
Dealers in securities may be individuals or business entities. Dealers purchase, hold, and sell securities to their customers in the ordinary course of their trade or business. Sometimes they maintain an inventory. Dealers are distinguished from investors and traders because they have customers and derive their income from marketing securities for sale to customers. Section 475 requires dealers to keep and maintain records that clearly identify securities held for personal gain versus those held for use in their business activity. Dealers must report gains and losses associated with dispositions of securities by using the mark-to-market rules discussed below.
Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. The law considers this to be a business, even though a trader does not maintain an inventory and does not have customers. To be engaged in business as a trader in securities, you must 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; and
- 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; and
- The amount of time you devote to the activity.
If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a day trader, you are an investor. A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to the securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader's records on the day he or she acquires them (for example, by holding them in a separate brokerage account).
Traders report their business expenses on Form 1040, Schedule C (PDF), Profit or Loss From Business. The Schedule A limitations on investment interest expense, which apply to investors, do not apply to interest paid or incurred in a trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. See Topic 703, Basis of Assets. Gains and losses from selling securities from being a trader are not subject to self-employment tax.
Traders can choose to use the mark-to-market rules, investors cannot. If a trader does not make a valid mark-to-market election under section 475(f), then he or she must treat the gains and losses from sales of securities as capital gains and losses and report the sales on Form 1040, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. When reporting on Schedule D, both the limitations on capital losses and the wash sales rules continue to apply. However, if a trader makes a timely mark-to-market election, then he or she can treat the gains and losses from sales of securities as ordinary gains and losses (except for securities held for investment - see above) that must be reported on Part II of Form 4797 (PDF), Sales of Business Property. Neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.
In general, a trader must make the mark-to-market election by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. You can make the election by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:
- That you are making an election under section 475(f);
- The first tax year for which the election is effective; and
- The trade or business for which you are making the election.
Refer to the Form 1040, Schedule D Instructions (PDF), Capital Gains and Losses, for more information on how to make the mark-to-market election.
After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2011-14 (revenue procedures are available on IRS.gov). In addition to making the election, you will also be required to file a Form 3115 (PDF), Application for Change in Accounting Method. Publication 550 describes the procedures for making an election under the section called "Special Rules for Traders in Securities."
If you have made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to request and receive written permission from the Service to revoke the election. Non-filing of the Form 3115 mentioned above will not invalidate a timely and valid election. To request permission to revoke your election under section 475(f), you must file a second Form 3115 and pay a fee.
Page Last Reviewed or Updated: December 23, 2014