How Do Day Traders Handle Taxes?

Last Updated on July 14, 2021 by Editor Team

Are you thinking about becoming a day trader but aren’t quite sure what your tax liability would be after a full year of self-employment? Don’t worry, most people who have never day traded don’t have a clue about the subject. Fortunately, for the vast majority of people who take part in daily buying and selling of stocks and other securities for profit, the taxation rules are pretty clear and easy to understand. There are four main concepts, however, that every prospective day trader should know about.

Meeting the Definition

What makes a person, according to the federal taxing authorities, a day trader? The IRS uses a three-part test to come up with an answer to that question. First, your main goal should not be to earn income from capital appreciation, dividends, or interest, but from the daily price changes of the securities that you buy and sell.

Second, the activity must be substantial, which usually is interpreted to mean that you do it more than on a casual basis and often for at least four days per week. You should consider it as a way that you make a living, even though it’s okay to have other jobs. In other words, day trading does not have to be your main source of income, just a source of income, and a substantial one at that. Finally, you’ll have to engage in the activity with what the government calls regularity and continuity, which is nearly self-explanatory, but typically means that you’re not doing it as a sometime hobby or for a few months to make extra money.

Risk Management

One of the best ways to minimize your financial (not necessarily your tax) burden while operating a home-based day trading business is to practice careful risk management. In fact, when you’re able to exercise excellent risk management skills, losses will be minimized, even on losing trades. Much of this particular skill is about setting planned stops before ever entering a position, even if you only plan to stay in for a minute or less.

Smart stop setting is just one part of risk management. Another part is position sizing, which relates to the amount of capital you spend on any given trade. Most experienced day trading practitioners use some version of the two-percent rule. In other words, they never take a position with more money that a fixed percentage of their total account balance.

Short-Term Capital Gains

In most cases, every dollar of profit you earn will be taxed at short-term capital gains rates, which are that same as your personal income tax rate, whatever that is. By its very nature, the activity of day trading is a short-term way of making money on positions in the market.

Deduct Home Business Expenses

If you’re self-employed, which most day traders are, be ready to pay self-employment tax as well as income and short-term capital gains taxes. But, the one shining light in the situation is that you’ll usually be able to deduct all sorts of business expenses, like the cost of equipment, professional organization memberships, home office expense (the home office deduction), and more.