If you are trading stocks, registering a net profit at the end of the year is both good and bad news. The good news is that you made money, while the bad news is Uncle Sam will want its share of the profits. How much you will owe in taxes as a result of your trading activity depends not only on how long you have held the assets before selling them but also on whether you trade stocks for a living.
Long-Term Capital Gains
The Internal Revenue Service prefers you to hold on to your stocks for at least a year before you sell them. If you make money from selling a stock that you bought a year ago or longer, the profit qualifies as a long-term capital gain and is taxed at 15 percent. If your total income for the year qualifies you for a tax rate of under 25 percent, you pay no taxes at all for long-term capital gains. In other words, the tax rate that applies to long-term capital gains is always less than the rate you pay for ordinary income, such as wages.
Short-Term Capital Gains
If, on the other hand, you profit from selling a stock that you held for less than one year, the income is considered a short-term capital gain and taxed at your regular tax rate. The net tax rate for short-term trades will therefore depend on your total taxable income for the tax year.
While holding stocks for only a brief period is a disadvantage from a tax perspective, there is an exception. If you are trading very frequently and qualify as a professional trader per IRS rules, you can deduct expenses you incur during trading from your trading profits. The deductible expenses include subscriptions to professional publications including magazines and websites, courses and seminars you attend to improve your trading skills and so on. If you are using part of your home exclusively for trading purposes, you may also deduct a part of your housing costs from your income.
Professional Trader Qualification
Unfortunately, the IRS does not provide a clear definition of what constitutes a professional trader. Previous court cases, however, shed some light on the issue. Ideally, trading should be your full-time job and not something you do in your spare time after you fulfill other professional obligations. You should have established a regular trading pattern, meaning that you should not skip many business days without a single trade. While the IRS has not declared a definitive rule regarding the minimum number of trades you must make to be considered a trader, Smart Money estimates, based on previous court cases, that around a thousand trades a year could potentially qualify you as a trader and 5,000 per year is almost certainly sufficient to pass the test.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.