In this blog post, learn how to defer income, deal with wash sale losses, make a valuable Section 475 election, maximize trader tax status, accelerate itemized deductions, reduce under-estimated tax penalties, and make smart moves with your retirement plans.
Tax deferral for 2016
If there’s going to be tax reform in 2017, it’s safe to assume it will include a meaningful reduction in tax rates for all tax brackets. It’s probably wise to defer income and accelerate deductions at the end of 2016.
Trump and Congress may significantly reduce tax rates
The 2016 top individual tax rate is 44%, but it may be reduced to 33% for 2017 by Trump and House tax cut plans, delivering a significant 11% reduction. The top official rate for 2016 is 39.6%, plus there’s an additional 3.8% Obamacare Net Investment Income Tax (NIIT), and itemized deduction phase-out (Pease), which effectively means the rate is 44% rate for taxpayers with investment income — which includes traders. (Trump’s Treasury Secretary pick Steven Mnuchin was quoted in USA Today on Dec. 1 saying “Any tax cuts that we have for the upper class will be offset by less deductions to pay for it.”)
Try to delay business, investment income, and other types of revenue until 2017. For example, why pay Obamacare net investment taxes in 2016 if you can defer investment income to 2017 when Republicans promised to repeal Obamacare taxes? (Learn more about Obamacare taxes.)
Be cognizant of “constructive receipt of income” rules, whereby it’s not possible to defer income and pass IRS muster. (Read Some Proprietary Traders Under-Report Income.)
Consider “tax loss selling” of investments and trading positions. That’s where you let profits run on open securities positions and sell losing positions to realize tax losses before year-end. Be careful not to trigger a wash sale loss by buying back a substantially identical position 30 days before or after incurring the loss. A wash sale loss with a taxable account at year-end postpones the loss to 2017, which would ruin your plan to accelerate losses with tax loss selling.
Avoid wash sale losses in 2016
Avoid getting stuck with a wash sale loss at year-end in taxable accounts, and avoid them throughout the year with IRAs. If you have a large capital loss carryover, then wash sales with taxable accounts may not change your $3,000 capital loss limitation — but you must account for wash sales. Wash sales are a primary concern for securities traders using the default realization (cash) method, but not Section 1256 contract and forex traders as those instruments are exempt.
A concern for tax preparers is that the IRS requires brokers to prepare 1099-B wash sale loss adjustments based on identical positions, per that one account. The IRS asks taxpayers to go a step further: To calculate wash sales on Form 8949 based on substantially identical positions, across all accounts, including IRAs. Example: A broker 1099-B does not calculate a wash sale on Apple equity vs. Apple options because they are not identical positions (symbols), but the IRS asks taxpayers to do so because they are substantially identical positions. (Including options at different expiration dates.)
Consider a “Do Not Trade List” to avoid permanent wash sale losses between taxable and IRA accounts. For example, trade tech stocks in your individual taxable accounts and energy stocks in your IRA accounts. Otherwise, you can never report a wash sale loss with an IRA, as there is no way to record the loss in the IRA.
Break the chain on wash sale losses at year-end in taxable accounts to avoid wash sale loss deferral to 2017. If you sell Apple equity on Dec. 20, 2016 at a loss, don’t repurchase Apple equity or Apple equity options until Jan. 21, 2017, avoiding the 30-day window for triggering a wash sale loss. Wash sale loss adjustments during the year in taxable accounts can be realized if you sell/buy those open positions before year-end and don’t buy/sell them back in 30 days.
Many tax preparers, including CPAs, import or attach broker 1099-Bs to generate tax return Form 8949 (Sales and Other Dispositions of Capital Assets); they don’t account for wash sales based on IRS rules for taxpayers. It’s become a widespread industry practice, and I have not heard about the IRS challenging it to date. If you plan to use this industry practice (at your risk), it’s wise to avoid wash sale loss conditions in the first place, so there are few gaps in broker vs. taxpayer rules. The crucial period is Dec. 1 through Jan. 31, covering the 30-day window on each side of year-end for triggering wash sales among taxable accounts. (That includes both spouses’ accounts on a married filing joint tax return.)
If you know you have wash sale loss conditions that the broker will not account for on 1099-Bs, then you should consider trade accounting software that’s compliant with wash sale rules for taxpayers. Download the original trade history from your broker’s website into a compliant program to generate Form 8949 or Form 4797 with Section 475.
Section 475 Election & Section 481(a) adjustment
We have always recommended that our trader tax status (TTS) clients elect Section 475 MTM on securities for ordinary gain or loss treatment, which exempts Section 475 trades from wash sale losses and capital loss limitations. (There is one exception: If the trader has a large capital loss carryover, they prefer to retain capital gains treatment until they use up their capital loss carryover, as Section 475 is ordinary income.)
It’s too late to elect Section 475 in 2016 for existing TTS individuals and entities; the election deadline was April 18, 2016 for individuals and partnerships and March 15 for S-Corps. Without Section 475, traders are stuck with a capital loss limitation and subject to wash sale loss rules. (A “new taxpayer” entity may elect Section 475 internally within 75 days of inception.)
Consider filing a 2017 Section 475 election statement with the IRS by April 15, 2017, for individuals and March 15, 2017, for existing S-Corps and partnerships.
Under current law, a 2017 Section 475 election takes effect on Jan. 1, 2017. Unrealized gains and losses on open TTS securities positions at year-end 2016 are captured in Section 481(a) adjustments made on Jan. 1, 2017. The Section 481(a) adjustment is ordinary gain or loss.
An ongoing IRS Clean Up Project for Section 475 might change some of these rules in 2017, which would be worse than the current law. The IRS hinted it may require a Section 481(a) adjustment to be capital gain or loss treatment, rather than ordinary income or loss. The IRS may also institute a “mark and freeze” election so the effective date would be the election day, not Jan. 1.
Tax reform may repeal the two-year NOL carryback rule, only retaining NOL carryforwards. Since 1997, Section 475 MTM traders benefited from NOL carrybacks; they received quick refunds replenishing their trading capital.
Trader tax status offers business tax breaks
If you qualify for TTS (business expense treatment — no election needed) in 2016, accelerate trading expenses into that qualification period as a sole proprietor or entity. Consider purchasing new equipment and other expenses before year-end 2016. Under the cash accounting method, a current year deduction is allowed for an item purchased by credit card or check by Dec. 31, even if you don’t take delivery until after Dec. 31.
If you strongly expect to qualify for TTS in 2017, but not 2016, consider deferring trading expenses until 2017. I don’t expect that tax reform will undermine TTS business expense treatment. Investment expenses are limited under current tax law and the House plan eliminates miscellaneous itemized deductions including investment expenses in 2017. Accelerate investment expenses into 2016 if you exceed the 2% AGI threshold for this deduction and don’t trigger AMT.
Itemized deductions will likely change with tax reform
To help pay and offset a reduction in tax rates, Trump, and Congressional tax plans reduce tax loopholes, including itemized deductions.
Before finalizing your 2016 tax plans, look at the Trump tax plan and House tax reform framework. If you stand to lose some itemized deductions in 2017, consider accelerating those deductions into 2016, where you may benefit more.
For example, the House framework states “All itemized deductions would be eliminated except for the mortgage interest and charitable giving deductions.” State taxes included in itemized deductions, including income, real estate, and property taxes would be repealed under the House plan. The Trump plan allows existing itemized deductions, but limits itemized deductions overall to “$200,000 for Married-Joint filers or $100,000 for Single filers.” Both plans raise the standard deduction to compensate for these changes.
Clients may prefer to prepay all types of state taxes and other itemized deductions in 2016 to ensure deductibility. Keep an eye out for alternative minimum tax (AMT) in 2016 which does not allow some itemized deductions including state taxes and investment expenses. Both Trump and House plans repeal AMT for 2017.
Estimated income taxes for 2016
Many traders underpaid their 2016 estimated income taxes since they feared losses later in the year and/or wanted to reinvest their capital. Many view under-estimated tax penalties as a form of margin interest. They should consider making a timely Q4 estimated tax payment by Jan. 15, 2017 to limit under-estimated tax payment penalties. Consider prepaying the state income tax voucher by Dec. 31, 2016, if it lowers your federal tax bill and does not trigger AMT.
Deferring income to 2017 reduces 2017 estimated taxes, too. It reduces the 2016 “safe harbor” threshold.
S-Corp traders can increase tax withholding on year-end compensation to avoid under-estimated tax penalties since the IRS treats tax withholding as being made throughout the year. (Read Still Time For Trading Entities To Make Valuable Year-End Tax Moves.)
Choose traditional over Roth retirement plan for 2016
Maximizing a “traditional” retirement plan tax deduction for 2016 is an excellent way to reduce 2016 taxes while deferring income for many years until retirement when tax rates on retirement distributions may remain lower. Plus, you can trade the retirement plan for tax-deferred growth.
Conversely, with a Roth retirement plan contribution, you don’t get a current year tax deduction, and retirement distributions are tax-free. Consider that tax deductions may be more valuable in 2016 than in 2017, so consider a traditional retirement plan deduction for 2016, rather than a Roth contribution.
Postpone Roth IRA conversions
A Roth IRA conversion has been a wise idea for many years, but it may not be a good idea for 2016 if you expect a reduction in your tax rate for 2017. Consider holding off on doing a Roth conversion until 2017, when the tax bill for taking in conversion income might be at a lower tax rate.
Conversely, if you are in a low tax bracket or have a taxable loss in 2016, consider a Roth conversion before year end 2016. The IRS allows individuals to reverse (“recharacterize”) a Roth conversion in the subsequent tax year, by Oct. 15th if on an extension. If Congress significantly reduces your tax rate for 2017, or for any other reason, you can unwind the 2016 Roth IRA conversion. It’s worth the effort in this case to do it.
There are many other potential tax planning opportunities for savings, and it’s best to work directly with your tax advisor to flush them out. Every client file is different. Get a handle of your trade and other accounting so you can make decisions based on fact rather than projection. Whenever tax rates and law change from year to year, it makes year-end tax planning paramount!
My partner Darren Neuschwander, CPA contributed to this blog post.