What Robinhood Traders Need to Know About Taxes

By Laura Saunders

Joseph Holler started day-trading stocks last July when he was stuck at home during the pandemic and his work slowed down.

"It was fun and exciting. I enjoyed it," says Mr. Holler, a 38-year-old telecom salesman who lives near Huntsville, Ala., with his wife and their five children. Using several no-commission online brokers, he sometimes made more than 200 trades a day and thousands in 2020, according to brokerage records he provided. Overall, he says, he's ahead by more than $8,000.

Now this fun will be put to the test by Uncle Sam: This week Mr. Holler received his first tax document, a 1099 form detailing a small portion of his trades. It's 34 pages long.

"It's so convoluted, I have no idea what it means," says Mr. Holler, who has always prepared his own taxes using software. With hundreds more pages of records coming, he thinks he'll need to hire a professional preparer this year.

Mr. Holler will have plenty of company soon. The brokerage industry added over 10 million new retail accounts in 2020, a record year, according to analyst Devin Ryan of JMP Securities.

A large number of these were taxable accounts. Robinhood Markets Inc., which brought a flood of first-time traders into the markets both last year and during this year's GameStop frenzy, doesn't allow customers to trade within retirement plans such as Roth IRAs and 401(k)s, where sales aren't taxable.

New traders will wake up to the tax effects of their moves in coming weeks as they receive tax forms. Robinhood has told customers they can download theirs by Feb. 16.

Robert Green, a CPA with Green, Neuschwander & Manning, a firm specializing in tax issues for frequent traders, says that since 1978 he has never seen so much money made by 30-year-olds.

"I worry that losses are coming soon, and these people need to know the rules. Lots of traders owe more than a third of their gains in taxes each year, but it can take years to benefit from losses," says Mr. Green.

Carlos Diaz, a 23-year-old software salesman based in Atlanta, says his $3,000 account is up more than 30% in the past year. But he says he's only starting to learn about how losses can offset gains and the timing issues that come into play.

"I've heard that taxes affect the bottom line, and I want to know more," he adds.

Whether you day-traded last year or just joined the fray and won't reckon with the IRS until April of 2022, here's what's important to know.

The ground rules

Investment income is taxed very differently from wages or gig earnings -- in good ways and bad.

No Social Security or Medicare tax (combined total: up to 15.3%) is due on this income. But there's also no tax withholding when selling a winner, as there is when an employer sends part of your paycheck to the IRS. Brokers report each sale to the agency, even if the gain or loss is a few cents.

So traders who sell winners need to set aside cash or have a strategy for paying taxes when they come due. Estimated quarterly payments may also be required, and there's a penalty for noncompliance. For more details on this complex area, see IRS Publication 505.

Long-term versus short-term

Taxpayers who hold investments longer than a year before they sell are eligible for favorable tax rates of up to 23.8% on their profits, known as capital gains.

Most day traders don't qualify for these rates because they sell within a year, so their gains and losses are classified as short-term, and their net gains are taxed at the higher rates for ordinary income such as wages. These rates range from 10% to 37%, plus a 3.8% surtax for higher earners.

State tax is often due as well. California has a top income-tax rate of 13.3% with no reduced rate for capital gains, so a top-bracket frequent trader there could owe half his gains to federal and state taxes.

Offsetting gains and losses

Nobody wants a loss, but the tax code allows investors to put them to good use by offsetting capital gains. So if a trader has $10,000 of capital gains and $9,000 of losses after sales in the same calendar year, then she or he has a taxable gain of $1,000. On the other hand, $9,000 in gains and $10,000 of losses amount to a net loss of $1,000.

Unused losses can offset up to $3,000 of income such as wages, and the rest carries forward to reduce future gains or else $3,000 of ordinary income a year.

Investors who are selling only some shares of a holding bought at different times can specify which shares they want to sell. For example, someone who owns shares in XYZ Co. bought at $5, $10 and $15 might want to sell the $15 shares if the price is $17, in order to lower the tax bill. Traders who want to specify shares need to arrange this with their brokerage firms, or the firm will typically use FIFO -- first-in, first-out.

Timing issues

There's an important catch: Capital losses can't offset gains as usual if the investor buys the same holding within 30 days before or after a sale at a loss, even if the stock is in a different account. This is called a "wash sale."

However, wash-sale rules don't apply to stocks sold at a gain. So if an investor sells a loser with a $10 loss per share and a winner with a $10 gain per share in the same year, then the trader can re-buy the winner right away.

In taking profits and losses, timing matters. For example, say that a trader made sales in 2020 and had net gains. If she then sold losers early in 2021, those 2021 losses can't carry back to offset the 2020 gains. The 2021 losses can shelter future gains, but taxes on the 2020 profits will be due on April 15, 2021.

Options

Many GameStop traders have used options rather than purchasing shares outright, in part because they cost less than shares. Options are the right to buy (through a "call") or sell (through a "put") a certain number of shares of stock at a certain price within a specified time frame.

Options are securities, and the regular taxes on capital gains and losses apply to them, says Darren Neuschwander, another CPA with Green, Neuschwander, & Manning. So if a trader buys a call option and then exercises it, the purchase price of the option is added to the cost of the stock. If the option expires worthless, the trader has a capital loss for the price of the option. This area is often complex, so consider professional help.

Silver

Recently some retail traders have moved from stocks to silver, and the taxes in this area depend on how the metal is held. Physical silver, such as an ingot, is a "collectible" according to the tax code. Short-term gains are taxed at ordinary income rates, and long-term gains (those held longer than a year) are taxed up to 28%. These rates typically apply to traders who invest through exchange-traded vehicles backed by physical silver, according to Tim Speiss, a CPA who advises high-net worth clients at EisnerAmper.

If the trading is in futures contracts that are a promise to buy or sell silver at a later date, then different rules apply, says Mr. Speiss. Typically gains and losses are automatically deemed to be 60% long term and 40% short term, no matter how long the position was held.

Frequent-trader status

A prized tax break allows some day traders to say their activity is a bona fide business. If so, they can deduct the cost of special terminals, a home office, business meals, tax prep and other expenses on Schedule C. They may also be able to deduct more than $3,000 of losses a year against ordinary income like wages. To be eligible for 2021, a new claimant to this status has to take steps by this April 15.

The requirements for getting this break are stiff and haven't been fully detailed by the IRS, although courts have defined them somewhat. Among other things, traders often need to trade for at least four hours a day for an average of four days a week in a given year and make more than 720 trades.

If a frequent trader also has a day job, location often matters. "It's easier for employees who live on the West Coast to qualify for trader tax status, because the markets open so early for them," says Mr. Neuschwander.

Tax preparation

Soon traders with taxable accounts will receive a Form 1099-B listing their trades. This form can run to hundreds or sometimes thousands of pages and raise a tax-prep bill by up to $1,000, says John Dundon, an enrolled agent in the Denver area who prepares returns for more than dozen active traders.

Brokers typically offer electronic forms for import into tax-prep software. How well this works depends on the software at both ends, says Mr. Dundon, and can be especially tricky if the trader held options that expired worthless or traded cryptocurrency. "If you've been day trading, don't assume you can do your taxes yourself," he adds. "A good tax pro can keep you from making grave errors that take more time and money to undo."

Write to Laura Saunders at [e-mail]

(END) Dow Jones Newswires

02-05-21 0544ET