Business Expense Treatment
Investment expense treatment is the default method for investors, but if you qualify for trader tax status, you can use the more favorable business expense treatment.
Qualifying for trader tax status (TTS) means you can use business treatment for trading expenses as opposed to the default investment treatment. TTS is also a precondition for electing Section 475 MTM ordinary gain and business loss treatment.
Business expense treatment under Section 162 gives full ordinary deductions, including home-office, education, Section 195 start-up expenses, margin interest, Section 179 (100%) depreciation, amortization on software, seminars, market data and much more. Conversely, investment expenses are only allowed in excess of 2% of adjusted gross income (AGI), and not deductible against the nasty alternative minimum tax (AMT). Starting in 2013, investment expenses are further restricted with “Pease” itemized-deduction limitations for taxpayers with AGI over $300,000 (married) and $250,000 (single). Many states limit itemized deductions too. The bottom line is business expense treatment is much better.
The average trader saves more than $5,000 per tax year with trader tax status, and hedge funds also save taxes for their investors. You can claim trader tax status after year-end; it doesn’t need to be elected in advance like Section 475 MTM and the forex election to opt out of Section 988. You can claim trader tax status for the tax year that just ended and even for the prior three tax years with amended returns by including a Schedule C as a sole proprietor on individual accounts. (Note: Filing amended tax returns may increase your odds of IRS questions or exam so be sure of your status.)
Full-time active traders generally qualify for trader tax status quite easily. Part-time traders can also qualify, but it’s more difficult. The bar is raised in the eyes of the IRS — especially if you have trading losses with business ordinary-loss treatment (Section 475) rather than capital-loss limitations.
For more in-depth information about business expenses for traders, including special rules for education expenses, startup expenses, home office and other expenses, read Green’s Trader Tax Guide. Our companion tax return examples guides show many tax returns with all sorts of business expenses for traders.
Visit these other Trader Tax Status pages to learn more:
How to Qualify — it’s nuanced and our golden rules help.
Section 475 MTM Accounting — elect “tax loss insurance.”
Employee-Benefit Plans — deduct retirement plans and health insurance premiums.
Defend it with the IRS — How to win when an auditor challenges TTS.