Monday, February 22, 2021

Buzz Kill: Day Traders May Be In For Some Nasty Shocks From The Tax Man

 


As we read the news (WSJ, Feb. 16, p. B14) that the stock of the video game retailer Game Stop has fallen 80 percent from its late January peak, one wonders what tax hits await the armchair traders.  Will they be in the form of dozens of pages of 1099 tax documents - such as hit a 38 yr. old day trader named Joseph Holler (WSJ, 'Day Traders, Here's Your Tax Bill', Feb. 6-7, p. B5)?  Or will the shock be in the form of actual taxable hits?

Oh yeah, these armchair day traders - including a lot of kids (needing a new activity apart  from video games) -  have had a lot of fun.  Beats playing  Fortnite for 12 straight months -  or computer chess -  but now reality is about to pay a visit.  One thing for certain, newly minted traders will wake up to the tax effects of their hobby in the coming weeks as they receive bundles of tax forms.  In the words of the guy Holler, cited earlier:  "It's so convoluted I have no idea what it means. I think I will need to hire a professional!"

Ah well.  What are some of the other aspects the day trading hobbyists might need to learn?

The good news?  No Social Security or Medicare FICA taxes are due on this income.  But, there's also no tax withholding when selling a winner, say like when an employer sends part of your paycheck to the IRS.  What happens is that your broker,  commission paid or no,  sends each sale to the IRS even if the gain is only a few cents.  (This is how Mr. Holler will end up with over 200 pages of 1099 tax documents). 

 The takeaway here? Day traders who sell winners need to set aside cash or have a strategy for paying (estimated) taxes when they come due.   Quarterly payments may well be required and there's a penalty for noncompliance.   

More good news:  Those traders who hold investments longer than one year before selling are eligible for favorable tax rates of up to 23.8 % on their profits, known as capital gains. (Most day traders don't qualify because they sell within a year - so both gains and losses are classed as "short term".  

 The bad news for the short term  sellers is their net gains are taxed at higher rates, e.g. for ordinary income such as wages. These higher rates can range from 10 % to 37% - plus 3.8 % surtax for higher earners.   Then there is the state tax which may be due as well.  If the day trader happens to live in California he or she may be looking at a top income tax rate of 13.3% with no reduced rate for capital gains.  A top bracket frequent trader could conceivably see one half his gains going to federal and state taxes.  

As for losses. there have been a lot of them - say for GameStop traders- in the past month.   The good news is that the tax code allows traders to put losses to good use by offsetting capital gains. So if a traders has $10,000 of capital gains and $9,000 in losses after sales - in the same calendar year- then this yields a net taxable gain of $1,000.  Conversely, $10,000 in losses and $9,0000 in gains amounts to a net loss of $1,000.    Here it's also useful to know that unused losses can offset up to $3,000 of income such as wages.  Any balance carries forward to reduce future gains, or $3,000 in ordinary income a year.  

 One little detail that often snags armchair day traders concerns timing.  Thus, capital losses - say in your GameStop shares-  won't offset gains if the trader buys the same holding within 30 days before or after selling at a loss.  That's even if the stock is in a different account.  (This is called a "wash sale".)   Wash sale rules don't apply to stocks sold at a gain.  So if a trader sells a loser with a $10 loss per share and a winner with a $10 gain per share - in the same year- the trader can rebuy the winner right away.  

 Timing matters from year to year, again taking GameStop shares as an example.  Say a GameStop trader had sales last year- say at the end - and racked up $12,000 in net gains.  Then as GS shares dived early this year the trader sold the losses - and those amounted to $12, 500.Alas, these losses can't carry back to offset the 2020 gains - so the trader is stuck with that tax bill on the $12,000 net gains.   What about the 2021 losses?  Well they can shelter future gains, just not the previous year's.  

 Lastly, there is frequent trader status to consider.  The benefits for claiming this status include:

- deducting the cost of a home office, including special terminals

- deducting business meals, tax prep and other expenses  all on Schedule C

To be eligible - according to general iRS current rules (which have yet to be specifically detailed by the IRS), the trader wold need to rack up at least 4 hours a day of trading for 4 days a week in a given year.   Oh, and make more than 720 trades.

Like to trade a lot, day to day, to break the lockdown monotony?  One buzz kill is that soon the army of Game Stop (and other) day traders will receive a Form 1099 -B listing all these trades they may have forgotten. But when they receive hundreds of pages for the 1099-B they will know they haven't.  

Got $1,000 in cash left in your Game Stop account?  You may need it for the tax preparer.   According to one Denver tax accountant:  "If you've been day trading don't assume you can do your taxes yourself."

Yep, day trading can be a spiffy way to break the monotony of an ongoing pandemic, but be assured the tax man can make things even more "interesting".  





























 terms of tax obligations.   Well, what are some that the young trading Turks need to be mindful of?

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