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IRS Limits to Qualified Day Trading Expenses

The IRS lets you offset your profits from day trading with the expenses that are incurred to make those profits. Things like legal and accounting fees, the expenditures to set up your office, and interest paid on loans to leverage your positions can be legitimate expenses. But your deductions may be limited, especially if you do not meet the IRS definition of trader.

To the taxmen, you are a trader only if all of the following apply to you:

  • You seek to profit from daily market movements in the prices of securities, not from dividends, interest, or capital appreciation.

  • Your activity is substantial; the IRS code does not spell out what substantial means, but it probably means you’re making at least 3,000 trades per year.

  • You carry on the activity with continuity and regularity. In other words, day trading is more or less your full-time job, you’ve stuck with it for at least six months already, and you plan to keep trading into the next year.

If you trade part-time, have other employment, or are new to the day trading game, the IRS probably won’t let you define yourself as a trader.

At-risk rules

The IRS says that your loss is limited by the amount of property you contribute to your investing activities, including money you borrow. In most cases, day trading losses meet the risk definitions, but if you pursue a naked trading strategy that causes you to lose more than your initial investment, you may fall into this category.

Passive activity losses and credits

The IRS defines a passive activity as an investment where the investor does not play an active role but does make money. You can deduct passive activity losses only up to the amount of your passive activity income, and you can use credits from passive activity losses only against tax on the income from passive activities.

Day trading is generally considered to be active, because you are materially participating, but if you are generating passive losses from other investment activities, you probably won’t be able to use them to offset your day trading gains.

Interest expense limitations

The IRS allows you to deduct investment interest up to the amount of your net investment income, which is your investment income less all your allowable deductible expenses except for interest. If you lost money trading, you can’t use the interest deduction to reduce your taxes. What you can do, though, is carry the undeducted investment interest into next year and use it to reduce your taxes on those profits.

You also can’t deduct interest expenses on straddles. A straddle is an options strategy that involves buying both a put option and a call option on the same stock with the same strike price and expiration date. In most cases, the nondeductible interest and related carrying charges are added to the basis of the straddle (just as commissions are).

Two-percent limit

If you do not qualify as a trader to the IRS, you can deduct investment expenses and other miscellaneous itemized deductions only if they add up to more than 2 percent of your adjusted gross income.

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