Investor vs. Trader: Why it Matters for Tax Purposes
posted Mar 18, 2019 by Paul Nadeau Jr., CPA, MST in the Global Tax Blog
If you participate in the securities markets, whether you’re considered an investor or a trader can have a significant impact on your tax bill. And the effect could be even more dramatic under the Tax Cuts and Jobs Act (TCJA), the federal income tax overhaul passed in late 2017.
What’s Your Status?
For tax purposes, the distinction between qualifying as an investor or a trader largely comes down to the frequency and goals of your trades. Investors generally buy and sell securities to earn income from dividends, interest and capital appreciation. And they typically hold on to securities for at least a year.
On the other hand, traders are in the business of regularly and continually buying and selling securities for their own account. They trade frequently in pursuit of profits based on daily market movements and expect trading to provide their livelihood.
In general, the tax rules favor traders over investors — and the TCJA has made investor status even less tax advantageous.
How Has the TCJA Changed the Rules for Investors?
Under prior law — before the TCJA went into effect — investors could generally claim expenses related to their investment activity as miscellaneous itemized deductions subject to the 2% adjusted gross income (AGI) limitation. The limitation prevented some, but not all, investors from benefiting from their investment expenses.
Under the TCJA, itemized deductions for miscellaneous expenses above the 2%-of-AGI floor have been suspended until 2025. That means that investors can’t deduct their investment-related expenses, including fees for investment, legal and accounting advice. In addition, investors are subject to restrictions on investment interest expense deductions, the $3,000 capital loss limitation and wash-sale loss rules.
To add insult to injury, for 2018 through 2025, investors’ itemized deductions for state and local income, sales and property taxes are limited to an annual total of $10,000.
However, there are a few investor friendly provisions of the TCJA: First, it increases the standard deduction to $12,000 for single filers and married filing separately taxpayers and $24,000 for married joint filers for 2018. These increases may make up for suspended itemized deductions.
Under the TCJA, investors continue to be taxed at capital gains tax rates, rather than higher ordinary income tax rates. But capital gains tax rates were untouched by the new law.
How Has the TCJA Changed the Rules for Traders?
Under the TCJA, traders can still deduct their trading expenses as ordinary expenses, meaning the expenses reduce AGI and taxable income for alternative minimum tax (AMT) purposes. And state taxes are considered fully deductible expenses.
Traders also can make a mark-to-market election that allows them to avoid the capital loss limitation and wash-sale rules. But the biggest upside for traders under the TCJA is the new deduction on qualified business income (QBI) of up to 20% for eligible pass-through entities.
Proceed with Caution
Whether you’re an investor or a trader, the TCJA brings some major changes and complexities to the tax picture. We can help you determine what treatment best fits your activity and how to appropriately minimize your final tax bill.