Let’s say that you had a $30,000 loss one year. You can only deduct $3,000 every year until all $30,000 is deducted which would take ten years to do. If you had multiple losing years it could possibly take a lifetime to deduct all those losses. On top of that, there’s another rule. You can only claim losses provided that they do not violate the wash sale rule. The wash sale rule prohibits you from claiming losses on a stock if you bought the same stock either 30 days before or 30 days after you closed for a loss. If you bought a stock on one day and then a week later you sold that stock for a loss and then you decided that the next day you want to buy the same stock, you just made a wash sale and you cannot claim the loss that you had on that stock previously. So what could actually end up happening is you can have $30,000 dollars in losses total but only be able to deduct a portion of that because of wash sales. But if you’re a qualified day trader meaning you meet all the qualifications to be looked at as a day trader in the eyes of the IRS then the rules investors have to follow do not apply to you as long as you file section 475 and elect mark-to-market accounting for that trading year. When you make mark-to-market accounting there is no limit to the amount of losses you can deduct in one year. If you lost $30,000 you can deduct every single penny of that loss in one year and there is no wash sale rule. And if trading is your only income you can deduct that loss to prior years you made money in the market so if you made $100,000 last year but you lost $30,000 this year you can amend up to two years of income and actually get a refund.
But not everyone can elect Section 475 and get this special treatment. You have to be seen as an active trader in the eyes of IRS and qualify for trader tax status. In order to receive trader tax status you need to 1) trade regularly and continuously, meaning you are making trades every day. You are not making one trade a week or a few times a month. You are making on average four or more trades per day at least four times per week. 2) you must make it clear that you are trying to profit from short-term daily movements of the market and not long-term holding investments. Your average holding period should be less than 30 days. If you want to hold positions longer than 30 days then you need to do that in a separate trading account. I personally have two accounts for this reason. One account is for day trading and the other account is for long term investing. This way I can show the IRS that this is my trading account and it needs to be taxed as such and this is my investing account and it needs to be taxed as such. If I were to combine the two it would be impossible for the IRS to determine if I was a trader or an investor. 3) you should be spending at least three hours a day researching and making trades. This shows that you are actually participating in the markets and this is basically your job. Making a trade on your lunch break is not going to cut it. If you meet all three of these standards then you may be able to qualify for trader tax status and be able to elect mark to market accounting.
Now of course you never expect to have a bad year but you just never know what can happen and electing mark-to-market accounting is a nice safety net to have which can really save a substantial amount of money when it comes to ducting losses on your taxes. But in order to claim losses for the current year you must have filed section 475 before the tax deadline date which is in the middle of April. So if I filed section 475 before April 15th and 2019 was a losing year for me then I can deduct all the losses I had for 2019. But if I didn’t file, then the losses I have for 2019 can only be deducted up to $3,000. So for 2020, I would need to make sure that I file section 475 before the deadline so that if I have losses for 2020 I can deduct everything.
You only have to do this once. You don’t have to file section 475 every year. oOnce you elect mark-to-market accounting it’s there for life unless you file to take it off. Here’s an example of how this can save you some money. Most day traders have other sources of income. Maybe they run an educational business or they rent out real estate or work part-time somewhere else. Let’s say that you day trade in the morning as part of your income but you also work part time in the evening earning a w-2 from working at a hospital. When you work for a business under a w-2 every paycheck that you receive taxes are taken out that are sent to the IRS and those taxes are normally greater than what you will actually owe to the IRS at the end of the year which is why you normally get a refund when you file your taxes. Let’s say that you earned $30,000 from your hospital job and throughout the year you paid $4,000 in taxes on that income. But in your day trading account you lost $30,000. If you filed a section 475 you’re $30,000 loss will offset your $30,000 income you made from the hospital meaning you didn’t make anything in income that year. In fact, your income is negative 4,000 because your hospital job paid $4,000 to the IRS throughout the year. So in this case, the IRS owes you money because you have no income to be taxed on. So the IRS will give you all $4,000 back on your tax refund. But if you had not filed section 475 you would be taxed on $27,000 because you made $30,000 from your hospital job and you were only able to deduct $3000 from the $30,000 loss you had in your day trading account. When you subtract the $3,000 loss from the $30,000 gain at your job the IRS will say that you made $27,000 which will need to be taxed. The other $27,000 in your day trading losses will be carried over for the next nine years because you can only deduct $3,000 at a time every year. The refund you get all depends on what tax bracket you’re in and if you’re married or not but in this example I used a single person that is in the 12% bracket. If they get taxed at 12% on $27,000 then they would owe the IRS $3,240 giving them a refund of $760. Since they already paid $4,000 throughout the year at their hospital job. As you can see, having that section 475 can really help you out if you have a bad year in which you may need that money if you have a loss such as this example.
Please note that I am NOT a tax professional so I don’t know the full ins and outs of this subject. If you have any questions you should seek a tax professional that has experience with active day traders and ask them for advice tailored to your personal situation.