By Jim Forester, Tax Director of Traders Accounting*
Posted: September 14, 2007

The Internal Revenue Service has two tax classifications for individuals who buy and sell securities, mutual funds, options, futures, commodities and other derivatives: Trader and investor.

The minority who trade for a living under the IRS definition are classified as traders and afforded an attractive menu of tax breaks. The majority, who trade part-time in addition to full-time W-2 employment or as a retirement hobby, do not enjoy the tax advantages that accompany trader status.

So, how do the two match up come tax time? If your trading left you in the black, you could save thousands. If your trading resulted in a substantial loss, however, the ability to write off that loss in the year it occurred could result in a windfall of $20,000 or more.

How Traders Trump Investors

As a trader, you trump investors in two main ways: You can fully deduct all of your trading expenses, and you can write off 100 percent of your losses in one year (provided you elected the mark-to-market accounting method).

Investors who itemize their deductions on Schedule A are limited to a handful of deductible investment expenses, including legal and accounting fees, investment counseling and advice and investment newsletters. These must be listed as miscellaneous itemized deductions and can only be deductible to the extent that they exceed 2 percent of adjusted gross income.

As a trader, however, you can deduct all your business-related expenses, including your datafeed, dues and subscriptions, equipment, utilities, seminars, transportation, travel and entertainment. You can also take advantage of the home office deduction if you work from home.

So far, the IRS has left further delineation in the hands of the tax court, whose rulings tend to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Expense Deductions Add Up Fast

Here's how the additional expense deductions would benefit Janet Trader compared to Johnny Investor if both had identical trading gains and business expenses. Note that Johnny Investor is subject to the 2 percent threshold for the few deductible expenses he is qualified to claim:

• Total household income: $140,000
• Trading profits: $40,000
• Trading expenses: $24,230
• Janet Trader's tax savings: $7,269
• Johnny Investor's tax savings: $1,644
• Benefit of trader tax status: $5,625
• Risk insurance: The Capital Loss Deduction

When it comes to covering losses, traders fare even better: The IRS allows traders who elected mark-to-market to write off their entire loss in one year. You can even apply the loss to taxable income from past years and generate a tax refund!

Investors, meanwhile, have a maximum allowable net capital loss of $3,000 in any tax year. That means if you lose more than $3,000, your only recourse is to carry over the remaining balance until it's used up but, again, only to a maximum of $3,000 a year.

Here's how a $40,000 loss would affect Janet Trader and Johnny Investor. (Note that Janet Trader was able to offset her regular $100,000 income with her $40,000 loss while Johnny Investor is limited to the $3,000 capital loss deduction.)

• Total household income: $140,000
• Trading loss: <$40,000>
• Trading expenses: $24,230
• Janet Trader's tax savings: $19,269
• Johnny Investor's tax savings: $984
• Benefit of trader tax status: $18,285

Investors also face another limit: They may only deduct investment interest up to the amount of their net investment income, defined as total investment income (earnings, interest, dividends and royalty income) less the deductible investment expenses previously discussed. Any investment interest that exceeds that cap is non-deductible but may be carried forward to future tax years.

One of the best ways to secure and protect your trader tax status is to trade as a business entity. The IRS treats business filers in a far more consistent and advantageous way than it does individual traders.

*Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com Jim Forrester is Tax Director of Traders Accounting (http://www.tradersaccounting.com/)