HOW TO PREPARE TRADER TAXES - TradeLog (2024)

Trader taxes are one of the most complex parts of US tax law. Many traders and active investors excitedly jump into trading never thinking about taxes, or knowing what to expect. Then their first tax year ends and they receive 1099-B, perhaps with some shocking surprises. In this topic we explain some essential basics, potential problems, and important steps for preparing accurate trader tax reporting.

CONTENTS

Understand Basics

• Accounting Methods
• Capital Gains vs Ordinary Income
• Wash Sales

Very Important:

• The problem with 1099-B
• Can I use my 1099-B?
• Popular tax software challenges

Very Important:

• Steps for Preparing
• Other Considerations

UNDERSTANDING BASICS

Preparing taxes on trading activity starts with identifying your accounting method, which determines the reporting you’ll need.

Accounting Methods for Trading Accounts

Cash method– the default method of accounting used by most investors and many traders. Both short and long-term Investment and trading activity is typically reported as capital gains and losses. Wash sale rules apply to many instruments like stocks and options.

Trader tax status and section 475 mark-to-market election– aminorityof traders qualify for this method, and atimely election with the IRS is required. Qualified trading activity is reported as ordinary gains and losses, while segregated investment activity is reported as capital gains and losses.

Non-taxable accounts– Individual Retirement Accounts (IRA) don’t get reported to the IRS. However, if you trade substantially identical securities in both taxable and non-taxable accounts, you may need to adjust for IRA wash sales within the taxable accounts.

Capital Gains vs Ordinary Income

Ordinary income taxtypically applies to wages, tips and interest income. Basically, what you earn from your personal effort – your job, work, etc. The actual tax rate depends on your IRS federal tax bracket –click here to see rate brackets for 2023

Capital gains taxtypically applies to capital assets and investment income. This may include a home, as well as many financial instruments like stocks, options, mutual funds, etc. Capital gains fall into two sub categories:

• Short-term capital gains– if the holding period is 365 days or less, any resulting gain or loss from the sale of the asset is considered short-term. The tax rate is the same as ordinary income.
• Long-term capital gains– if the holding period is 366 days or more, the resulting gain or loss is long-term and results in generally more favorable tax treatment. This is to encourage investors to buy and hold capital assets longer.

2022 Long-Term Capital Gains Tax Rates

Capital losses– when the sale of capital assets results in a loss, those losses offset any gains throughout the tax year. If the net result is a loss, the loss can be applied against ordinary income. However, the IRS caps the maximum deductible capital loss to $3,000. If the net loss exceeds that amount, the balance is carried over to subsequent years.Capital loss carryover– the IRS allows taxpayers to apply capital loss carryover to offset capital gains, without limitation, for subsequent years.

Wash Sales

The wash sale rule is an important law which prevents a taxpayer from “cooking the books” with illegal tax loss harvesting. Making wash sale adjustments can be the most complicated part of preparing trader taxes.Learn all about wash sales in our separate guide.

THE PROBLEM WITH 1099-B

1099-Bis a broker-provided form, required by the IRS to report cost basis and proceeds for certain brokerage transactions. Most brokers report this information as part of a consolidated tax statement.Learn more about 1099-B reporting in our dedicated topic.

Myth: My 1099-B is all I need for reporting trading / investment taxes.

Fact:Unlike other 1099s or W-2 forms, the 1099-B may not provide complete or accurate information needed for tax filing.The IRS has different rules for broker reporting than for taxpayer reporting. This is why your broker 1099-B typically includes a statement reminding you of your accountability for accurate tax reporting.

Situations where your 1099-B may not be accurate enough for taxpayer reporting:

• If you have more than one brokerage account, or if you have anIRA account, then wash sale adjustments reported on the 1099-B are not complete. The IRS requires taxpayers to makeadditional wash sale adjustments across multiple accounts.
• If you trade options. Brokers do not adjustwash sales between stocks and options– and often not between substantially identical options, which is generally required for your taxpayer reporting.
• If you have electedsec. 475 Trader Tax Status, your 1099-B may not reflect the correct accounting methods for all securities. Even if you notified your broker you use mark-to-market accounting, there are other nuances to Trader Tax Status brokers are not required to account for.

TradeLog generates accurate, IRS ready tax reporting based on rules for taxpayers, not brokers. In addition, TradeLog includes functions for reconciling with the 1099-B and for making needed adjustments on IRS Form 8949.Click here to learn more about TradeLog.

Can I use my 1099-B?

You may be able to use your 1099-B directly to report details for Form 8949 if all of the following are true:

• I only have one brokerage account, or else I do not trade the same tickers in more than one account.
• I do not trade stocks and options in the same account, or in different accounts.
• I do not make trades for the same tickers in an IRA as my taxable account.
• I do not have any adjustments that need to be made for cost basis, special tax treatment, other accounting methods, etc.
• I do not care how my broker makes wash sale adjustments (see below).

If you are married and filing jointly, remember this would apply to both you and your spouse…

1099-B Wash Sale Deferrals May Hurt

Even if all of the factors listed above were true, many taxpayers have found broker methods for wash sale adjustments can cause painful results. For example: most brokers look for potential wash sales starting in the 30-day periodaftera loss occurs, which tends to defer the loss into the future. Those deferrals can snowball and sometimes result in more losses being deferred at year-end than actually occurred in the year.This can cause a taxpayer to be upside-down with a resulting capital gain, when they had a net loss – some CPAs refer to this as phantom income. Nobody likes having to pay taxes for money they didn’t make.

Did you know: The IRS wash sale rule states that a wash sale adjustment can be made to a replacement trade within 30 daysbefore or afterthe date of the loss. By first attempting to adjust a wash sale deferral to the 30-day periodbeforethe loss there is a greater chance of keeping losses within the tax year, and avoiding nightmare deferral situations. While these adjustments can be complex, TradeLog optimizes this part of the wash sale rule to benefit traders.

POPULAR TAX SOFTWARE – WHAT TRADERS SHOULD KNOW

Most people want to e-file using do-it-yourself software apps, the good news for traders is – you can; HOWEVER you need to understand something…

Myth: Popular tax programs can handle Schedule D Form 8949 reporting for traders and active investors.

Fact: Most tax software programs, like TurboTax®, usually rely on possibly-inaccurate broker 1099-B data for generating Schedule D Form 8949.Popular tax programs were made for the average taxpayer. Traders and active investors must comply with some of the most complex tax reporting requirements. As explained above, the 1099-B alone often is not enough. However, if a trader accurately prepares the specific forms and reports for their trading taxes, those can usually be used with popular tax programs.

TradeLog does not rely on 1099-B data, instead,TradeLog keeps a log of actual trade history which is used to generate accurate tax reporting. Most TradeLog generated tax reports can be used along with programs like TaxACT® and TurboTax® for completing your income tax return.Click here to learn more about TradeLog.

TradeLog has helped thousands of traders and active investors prepare tax reporting for over 20 years. Here are tried-and-true steps for preparing accurate reporting:

Gather Your Records

The IRS says you – the taxpayer – are responsible for maintaining accurate records of trade history.

Remember: you can’t blame your broker, or the 1099-B if something isn’t correct.

Save your monthly brokerage statements, these provide a history of trading, corporate actions, transfers, and a summary of month-end holdings.

Most brokers providedownloadable trade history reports. If using a third-party tool, like TradeLog, these reports can be imported to maintain accurate, independent records – and to generate tax reporting.

Match Trades to Figure Gain or Loss

To figure taxable gain or loss from trades you’ll next need to match the buy (cost basis) and sell (proceeds) records.The default matching method for most instruments is first-in first-out (FIFO), unless “Adequate Identification” is made.

If your broker executed the sale of positions using last-in first-out (LIFO), highest-in first-out (HIFO), or other methods, these come under the IRS umbrella of adequate identification. Employing this method requires meticulous records to clearly identify which shares were sold.

Average Basis method is an additional method that can be used for shares of mutual funds.

Matching gets complicated: a trader often buys and sells unequal shares of a stock or other instrument, typically on different dates. This may require dividing lots in order to properly match and account for later adjustments.

Once the buy and sell positions are matched,gain or loss is calculated as the difference between the cost basis and proceeds received.

Make Adjustments

Some required adjustments may include:

• Corporate actions – stock splits, mergers, etc.
• Option expiration – many brokers don’t create a closing position when this occurs
• Option exercise / assign – the IRS requires several adjustments to be made depending on the type of option position
• Adjustments to cost basis (or proceeds)

Calculate Wash Sales

Whenever a loss occurs for stocks, options, ETFs, and other wash-sale-required securities, you’ll need to search for a substantially identical “replacement” position within 30 days before or 30 days after the loss. If a “replacement” is identified, the loss is disallowed and a subsequent adjustment must be made to the cost basis of the replacement position. This gets very complicated. See our Wash Sales topic to learn more.

Manually making wash sale adjustments can be extremely tedious and time consuming. This is why tools like TradeLog are used.

Reconcile with 1099-B

While many traders and active investors cannot use the 1099-B directly for tax reporting, it can still be useful.

Reconciling your independent trade history with the 1099-B can help verify all trades are accounted for. This is not without challenges! Since brokers adjust wash sales and cost basis using different rules – that part won’t reconcile. Sales proceeds and/or quantity of shares/contracts sold may reconcile.

Most brokers vary in the format of 1099-B reporting. Gross sale proceeds is generally reported and is your best bet for reconciling quickly. This is the method used by TradeLog,click here to learn more.

Reconciling with 1099-B isn’t always easy and can even be impossible in certain situations.

Create Mark-to-Market Positions

Positions held open at year end need to be marked-to-market (MTM) using fair market value if:

• The trader qualified for Trader Tax Status and made a timely Section 475 election. MTM only applies to certain types of securities –click here to learn more.
• The positions are Section 1256 contracts, which always receive MTM treatment –learn more.

Segregate and Create Reports

Finally, in order to create reports, trades need to be segregated. Different types of trades are reported on certain forms, depending on the method of accounting:

IRS Form 8949 –Report short-term and long-term capital gains/losses for:

• Stocks / Bonds
• Options
• Single-Stock-Futures
• Mutual Funds
• Drips
• Exchange Traded Funds / Notes(ETFs/ETNs)
• Volatility Notes (Prepaid Forward Contracts)
• Warrants
• Cryptocurrency

IRS Form 4797 –For those who elect Section 475 Trader Tax Status, report the net sales of business property for qualified trades on line 10. Prepare a separate attachment statement detailing the profit/loss for:

• Stocks / Bonds
• Options
• Single-Stock-Futures
• Mutual Funds
• Drips
• Exchange Traded Funds / Notes (ETFs/ETNs), excluding Volatility Notes, or Foreign Currency Notes
• Warrants
• Section 1256 Contracts (if specifically elected)

IRS Form 6781 –For reporting Section 1256 contracts including:

• Futures
• Futures Options
• Commodities
• Commodity Options
• Broad-Based Index Options

Forex reportingcan depend on several factors. By default, gains/losses from forex trading receive Section 988 ordinary treatment and are reported on line 21 of IRS Form 1040.If qualified for trader tax status (business treatment), then report as ordinary gain or loss on Form 4797, Part II. Alternatively,traders can elect for capital treatment instead (section 1256), which then changes reporting to Form 6781.

OTHER THINGS TO CONSIDER

Some other tax prep related questions you may want to consider, especially if you’re serious about making trading your career, might be:

• Can I qualify to elect Section 475 Trader Tax Status?
• Should I form an entity?
• Are there other tax deductions for my trading business?

We recommend discussing these and other details of your unique situation with a qualified CPA specializing in trader taxes.