Taxes on day trading in Africa can leave you scratching your head. But if you mark hundreds or even thousands of flea markets each year, it’s in your best interest to understand how Uncle Sam will view your habit. Not only can you face a pile of paperwork, but those hard-earned profits may feel significantly lighter once the Internal Revenue Service (IRS) takes a cut. This page outlines tax laws, rules and implications. It will cover asset-specific provisions before concluding with key preparation tips, including tax software.
Investor vs Trader
So, how does day trading work with taxes? Intraday income tax will depend on the category in which you fall ‘trader’ or ‘investor’. Unfortunately, as an IRS spokesman pointed out: ‘The question is clear; the answer is not. ” You must therefore follow the guidelines set forth in the 70,000-page tax code and consider decisions in applicable case law.
Investor
If you don’t qualify as a trader, you will likely be seen as an investor in the eyes of the IRS. If this is the case, you will have a less advantageous daily tax rate in the United States. Your gains and losses must be accounted for on Form 8949 and Schedule D. Your expenses fall under the category of “various itemized deductions.”
This means you can’t claim a home office deduction and you have to depreciate equipment over several years, instead of doing it all at once. On Schedule A, you also combine your investment expenses with other items such as costs you incurred in tax preparation. You can also write off only the amount that exceeds 2% of your adjusted gross income.
Classification
The first step in reporting day trading taxes is to determine which category you will fit into. Investors, like traders, buy and sell securities. However, investors are not considered to own the trade or security. Instead, their benefits come from the interest, dividends and capital appreciation of their chosen bonds.
The crucial difference between whether you are entitled to deductions on page 1, as opposed to deductions from Schedule A against income, rests on whether you have a ‘trade’ or ‘business’ of selling securities.
The bad news is that ‘trade’ or ‘business’ is not clearly defined anywhere in the long tax code. Instead, you should look at recent case law (outlined below) to determine where your activity fits.
Trader
Spend your days buying and selling assets? If so, you likely fall under the dealer umbrella. A title that can save you serious cash when you need to file tax returns.
Classification
Day trading tax laws and recent cases tell us that you are a ‘dealer’ if you meet the requirements tested in Endicott vs Commissioner, TC Memo 2013-199. The two considerations were as follows:
1. The trade of the individual was considerable.
2. The individual aimed to profit from the price fluctuations in the daily market movements, rather than to profit from longer term investments.
In this case, the taxpayer’s primary strategy was to buy shares of stock and then sell put options on the underlying stock. His goal was to profit from the premiums received from selling call options against the correlating amount of underlying stock he owned.
He usually sold call options that had an expiration period of between one and five months. Endicott hoped that the options would expire, allowing the total amount of the premium received to turn a profit. He did not trade options on a daily basis, due to the high commission costs associated with selling and buying call options.
Endicott then deducted his trade-related expenses on Schedule C. This reduced its adjusted gross income. However, the IRS disagrees with the deductions and instead moves them to Schedule A. They insist that Endicott is an investor, not a trader.
Number of trades
One of the first things the tax court looked at when setting out the criteria above was how many trades the taxpayer carried out per year. They also looked at the total amount of money involved in those trades, as well as the number of days in the year on which trades were executed.
Endicott made 204 trades in 2006 and 303 in 2007. Then in 2008 he made 1,543 trades. The court ruled that the number of trades was not material in 2006 and 2007, but that it was in 2008.
Amount of money
In 2006, Endicott made purchases and sales totaling approximately $7 million. In 2007 the total was about $15 million, and in 2008 it was about $16 million. The court agreed that these amounts were substantial. However, they also said, “the management of a large amount of money is not unclear as to whether the operating activity of a filer constitutes a trade or a business.”
Important points
From this case and other recent tax rulings in Africa, a clearer picture emerges of what is required to meet the definition of ‘trader’. The most important are the following:
- You spend a significant amount of time trading. Ideally, this is your full-time occupation. If you are a part-time trader, you have to buy and sell multiple assets every day.
- You can demonstrate a regular pattern of making a large number of trades, preferably almost every day the market is open.
- Your goal is to profit from short-term price fluctuations, rather than long-term profit.
‘Dealer’ Benefits
The US tax rate on day trading looks favorable to the ‘trader’. Complying with their obscure classification requirements is worth it if you can. This is because, from the perspective of the IRS, you are the activity of a self-employed individual. This allows you to deduct all your trade-related expenses on Schedule C.
This includes home and office equipment. This includes educational resources, phone bills and a variety of other costs. However, it is important that you keep receipts for any items, as the IRS may request evidence to prove that they are used solely for business purposes.
On the other hand, if you are classified as a trader, you can write off the amount that is more than 2% of your adjusted gross income. Not to mention the Schedule C write-offs will adjust your gross income, increasing the chances that you can deduct all of your personal exemptions in full, and also take advantage of other tax breaks that are phased out for higher adjusted gross income levels.
Then there’s the fact that you can deduct your margin account interest on Schedule C. Throw in the fact that you don’t have to pay self-employment tax on your net profit from the trade, and you realize that this is a pretty sweet deal.
Market to Market Traders
There is another clear advantage and it focuses on the write-offs of taxes on day traders. Normally, if you sell an asset at a loss, you must write off the amount. If you, a spouse, or a company you control buys the same stock within 30 days, the IRS considers it a “wash sale” (further details below). This brings significant tax pain.
Fortunately, you can jump this hurdle by becoming a ‘branded’ trader. This will automatically exempt you from the wash sale rule.
Here’s what you do: on the last trading day of the year, you want to pretend you’re selling any shareholding. You still own those assets, but you book all the notional gains and losses for that day. You will then enter the new year with zero unrealized gains or losses. It appears as if you just repurchased all the assets you pretended to sell.
This brings another distinct advantage in terms of day trading profit taxation. Usually, investors can deduct only $3,000 or $1,500 of net capital losses each year. However, market-to-market traders can deduct an unlimited amount of losses. If you have had a poor trading year, you can save significant amounts.
If you qualify as a mark-to-market trader, you must report your gains and losses on Part II of IRS Form 4797. For further explanation, see IRS Revenue Procedure 99-17 in Internal Revenue Bulletin 99-7.
Wash-sale rule
There is an important point to emphasize regarding tax losses on day traders. In particular is the ‘wash-sale’ rule. This rule is set forth by the IRS and prohibits traders from claiming losses for trading in a wash sale.
A wash sale occurs when you trade a security at a loss, and then, within thirty days either side of the sale, you, a partner, or a spouse buy a “substantially identical” instrument. If the IRS disallows the loss as a result of the rule, you will have to add the loss to the cost of the new security. This would then become the cost base for the new security.
For further guidance on this rule and other important US trade regulations and provisions, see our rules page.
Application
How can you report taxes on day trading? If you are a trader, you report your gains and losses on Form 8949 and Schedule D. You can deduct only $3,000 in net capital losses each year. However, if you are married and using separate filing status, it is $1,500.
Schedule C should then have only expenses and no income, while your trading profit is reflected in Schedule D. To avoid confusion, a helpful tax tip is to include a statement detailing your situation.
You can’t join the most successful traders in the country, like Bruce Kovner and George Soros, if you end up at the tax gate. So pay the same attention to your tax return in April as you do to marketing the rest of the year.
Examples
Although not crystal clear, below are typical scenarios to help you see where your activities might fit.
- Example 1 – Let’s say you trade 8-10 hours a week and average about 250 sales a year, all within a few days of your purchase. The IRS is probably saying that you don’t spend enough time trading to meet the ‘trader’ criteria.
- Example 2 – Let’s say you spend about 20 hours a week trading and average about 1,250 short-term trades in a single year. The IRS should not put up a fight if you declare your promises as a day trader on your tax return.
It is also worth bearing in mind that you can be a ‘trader’ and ‘investor’. However, if you were to go down this route, you would need to separate your long-term businesses and keep detailed records to distinguish between both sets of activities.
Tax Terminology
You cannot understand the business of tax in Africa without understanding the essential tax jargon. A few terms that come up frequently are as follows:
Cost base
This represents the amount you initially paid for a security, plus commissions. This serves as a base figure from which taxes on day trading profits and losses are calculated. Closing out your position above or below your cost basis will create either a capital gain or loss.
Capital gains tax
A capital gain is simply when you make a profit from selling a security for more money than you originally paid for it, or when you buy a security for less money than you received when you sold it short. Both traders and investors can pay tax on capital gains.
Normally, if you hold your position for less than one year, it will be considered a short-term capital gain and you will be taxed at the ordinary rate. However, hold the position for more than a year and you can benefit from a lower tax percentage rate, often around 15%, but depending on your income, it can also drop to just 5%.
Capital losses
A capital loss is when you suffer a loss if you sell a security for less than you paid for it, or if you buy a security for more money than you received when you sold it short. For day trading tax purposes, you can often write off (deduct) capital losses, up to the amount of capital gains you earned this year.
If you have more losses than gains in a year, you can write off an extra $3,000 on top of your compensation gain. If your losses are more than the additional $3,000, you have the option to carry the losses forward to the next tax year, where you will have a further deduction allowance of $3,000.
Tax on specific assets
With wide differences between instruments, many people rightly question whether there are different tax provisions that you need to be aware of when trading in a variety of instruments. Generally, however, the IRS is more concerned with why and how you trade, than what you trade.
Day trading options and forex taxes in Africa are therefore usually very similar to stock taxes. With that said, there remain a number of asset-specific rules to note.
Futures
Profits and losses under term tax follow the ’60 / 40′ rule. The rate you will pay on your winnings depends on your income. 60% of the profit is treated as a long-term capital gain at a rate of 0% if you fall into the 10-15% tax bracket. If you fall into the 25-35% tax bracket, it will be 15%, and if you fall into the 36.9% tax bracket, it will be 20%. The 40% of the gains are considered short-term and are taxed at your ordinary income tax rate.
In general, tax implications on foreign exchange in Africa will be the same as tax on shares, and most other instruments. While futures options can offer interesting terms, the primary interest for all instruments is around ‘trader’ vs ‘investor’ status.
Tax Preparation
Keep a record
Many traders get to mid-April and suddenly realize that the IRS not only wants to know your profit and loss on each auction, but they also want a detailed description. If you want a simple tax rate on the day, you need to keep the following record:
- tool
- price
- Date of purchase and sale
- size
- Entrance and exit
Having this information at hand will make trading US stocks a stress-free process.
Day Trader Tax Software
Commercial tax software currently exists that can speed up the filing process and reduce the likelihood of errors. This tax preparation software allows you to download data from online brokers and collect it in a simple way. Simply put, it makes you plug the numbers into a tax calculator in the park.
This saves time, so you can concentrate on profiting from the markets. The enabled trader will use this new technology to improve their overall trading experience.
Final Word
Day trading and taxation are inevitably linked in Africa. Taxes on income will depend on whether you are classified as a ‘trader’ or ‘investor’ in the eyes of the IRS. Unfortunately, very few qualify as traders and can reap the benefits it brings. For those who are requested to produce their records in pursuit of the ‘dealer’ classification, they should be warned that the consequences of failure to pay the correct amount, or late payments, can have serious consequences. This can range from financially crippling fines and even jail time.
Note that this page does not attempt to offer tax advice. It seems merely to clear up the sometimes murky waters surrounding domestic income tax. If you are unsure or have any questions about day trading taxes, you should seek professional advice from an accountant or the IRS.