Charles Schwab : The Tax Moves Day Traders Need to Make Now

By Laura SaundersandMischa Frankl-Duval

If you're one of the millions of day traders who have jumped in and out of markets this year, check your taxes now. Being a taxpayer may not be top of mind, but not paying attention could dent your bottom line next April.

Trading by individuals has surged in 2020, fueled by no-commission trades, a rising market from March through August and free time provided by pandemic lockdowns. At Charles Schwab Corp., the average of 1.6 million daily trades for the second quarter was more than twice the year-earlier average of 716,000.

Easy-to-use mobile apps have contributed to the surge by attracting new, inexperienced traders. According to Robinhood Markets Inc., which offers the popular Robinhood trading app, first-time investors accounted for 1.5 million of its 3 million funded accounts opened in the first four months of 2020.

Many new traders likely aren't aware they are trading in taxable accounts, where each sale has tax effects. (Robinhood customers can't trade within retirement accounts such as traditional or Roth IRAs, where sales aren't taxable.) Next year, many will be surprised to receive long tax forms for 2020.

In 2017, college student Manessa Lormejuste was a little shocked to receive her first tax form from Robinhood, which ran to a dozen pages. She had no idea she could owe capital-gains tax on her trades.

Now 25, the cosmetic chemist from Linden, N.J., has since revised her strategies, monitoring gains and losses weekly, and she often holds positions for longer than a year to avoid the higher rates on short-term gains. "I try my best to minimize my taxes," she says.

With 2020 waning and the recent market selloff raising losses, frequent traders need to plan tax moves now. Here's what to keep in mind.

l Know the basics. The tax rules for investment income are very different from those for earned income such as wages. No Social Security or Medicare taxes are due on it, and there is no automatic withholding to set aside cash for income taxes. Estimated quarterly tax payments may be due.

In taxable accounts such as those offered by Robinhood, each trade can generate either a taxable gain or a loss that can offset a taxable gain. Savvy traders maximize after-tax profits by timing when they sell winners and losers, or by selling one lot of shares instead of another.

l Determine net gains and losses. Figuring the tax on a sale begins with subtracting the asset's purchase price (plus adjustments in some cases) from the sale price and recording a capital gain or loss. At tax time, the investor adds up gains and losses for the year and then nets them using a tax-law formula based on how long the asset was held before sale.

Example: Say that a trader bought shares in XYZ Co. at $5 each in June and then sold one share for $10 in August and another in September for $4. She records a $5 gain and a $1 loss, for a net taxable capital gain of $4.

If the trader's capital gains on sales exceed her losses on sales for the year, she owes income tax on the net gains. If the losses exceed the gains, there is no tax, and up to $3,000 of losses can be deducted against ordinary income like wages. If the trader has losses beyond that, they "carry forward" to offset future taxable gains until they are used up.

l Check your tax rate. It may be higher than you think. Day traders usually aren't eligible for lower rates that apply to long-term capital gains, because they are for investments held longer than a year.

Instead, frequent traders' net profits typically are short-term capital gains taxed at the higher rates used for ordinary income like wages -- a fact many traders overlook. If an investor's tax rate on a net long-term gain would be 15%, then the rate on a similar short-term gain will likely be 22% or higher, depending on income.

l Specify lots to lower taxes. Trading platforms, including Robinhood, usually allow investors to choose which shares they are selling if they have lots bought at different times. Doing this can lower taxes.

Say that a trader bought some shares of XYZ Co. at $5 and others at $7 and then sells a few shares for $9. Selling $7 shares will yield a taxable gain of $2 each, while selling $5 shares will yield a $4 taxable gain -- a big difference. If the investor doesn't specify which lot, the default is typically first-in-first-out, or FIFO, which often raises the tax bill.

l Beware of wash sales. Most trades in taxable accounts are subject to the "wash-sale" rules. A wash sale occurs when an investor buys a security within 30 days of selling at a loss, either before or after it. In that case, the investor can't immediately use the loss.

l Don't forget other taxes. There is a 3.8% surtax on net investment income above certain thresholds: $250,000 for married joint filers and $200,000 for singles. If a married couple has $150,000 of employment income and $110,000 of net taxable gains, then the 3.8% surtax would apply to $10,000.

Also be aware of state taxes. California has a top income-tax rate of 13.3% and no reduced rate for capital gains.

l Be careful about claiming trader tax status. A coveted tax break allows some day traders to claim their trading is a bona fide business and deduct expenses -- such as for specialized terminals, a home office or tax prep -- on Schedule C. If these traders also make a timely election under code section 475(f), they reap other valuable benefits.

Darren Neuschwander, a CPA with Green, Neuschwander & Manning, a firm that specializes in claims for trader status, says he has had a surge of inquiries about it this year.

The requirements for this break haven't been clarified by the IRS, but they are stiff. Among other things, traders often need to trade for at least four hours a day, for an average of four days a week, and make at least 720 trades a year, says Mr. Neuschwander.

Be ready for an IRS challenge, advises Robert Willens, an independent tax analyst. "The IRS jealously guards entry into this rarefied category, and the courts have often ruled against taxpayers," he says.

l Do year-end planning. Investors can't use losses on 2021 sales to reduce 2020 taxable gains. Mr. Willens advises traders with net losses near year-end to sell winners, if possible, to use the losses.

The wash-sale rules don't apply to taxable gains, he notes. So it is OK to sell a winner, book a gain, offset it with a loss, and rebuy shares right away.

l Expect tax paperwork. Next spring, traders with taxable accounts will receive a Form 1099-B listing their trades. This document can be voluminous and -- especially with options trades -- raise a tax-prep bill of $300 to $400 by several hundred dollars, says Dan Herron, a CPA in San Luis Obispo, Calif. who has active traders among his clients.

Trading firms often offer electronic forms for direct import into tax-prep software. Sometimes the import works well and other times it doesn't, says Mr. Herron. His rule of thumb: "The more complex the trading is, the more vague the reporting is -- and the higher the tax-prep bill."

Write to Laura Saunders at [e-mail] and Mischa Frankl-Duval at [e-mail]