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All About Taxes

It's that time of year again - Tax Season! Starting in January, brokers start sending out 1099 forms listing all your interest, dividends, and capital gains for the year. As a trader or investor, it's important to know how taxes can affect your profits. In this article, we'll explain some of the various tax rules that often apply to traders and investors.


Short-Term vs Long-Term


On the 1099-B you receive from your broker, your gains and losses will be divided into short-term and long-term. Short-term capital gains and losses are those for positions that were held for a year or less, while long-term are positions held for at least a year. The distinction is important because capital gains are subject to different tax rates depending on how long the position was held. Short-term capital gains are taxed at your ordinary tax rate, up to 37%, the same as any other income you earn. On the other hand, long-term capital gains receive favorable tax treatment - they are taxed at a lower rate of either 0%, 15%, or 20%, depending on your tax bracket. Most people will have their long-term capital gains taxed at 15%. However, people in the lowest tax bracket will not be taxed on their long-term capital gains, while people in higher tax brackets are taxed at a maximum of 20%.

Covered vs Noncovered


In addition to being separated into short-term and long-term, capital gains and losses are also classified as either covered or noncovered. Covered means that your broker reported your cost basis in the security to the IRS, so the information you report on your return for these securities must match what is reported on your 1099-B. Noncovered means that the cost basis is only reported to you, but not to the IRS. In either case, the proceeds may be reported to the IRS. You need to report the proceeds and cost basis on your return regardless of whether it is covered or noncovered. In some cases, the cost basis your broker provides for noncovered securities may be incorrect or incomplete, so you may need to keep your own records.


Form 8949

When you have capital gains and losses, you report them on your return on Form 8949. This form has two parts: Part I is for short-term transactions, and Part II is for long-term transactions. Each of these parts has three check boxes available to choose from, which denote whether the transactions are covered, noncovered, or not reported on 1099-B.


Your brokerage statement will tell you which box to check for all of your capital gains and losses. You can have up to 6 pages of the 8949 if you have transactions that fall under each category. The totals of the Forms 8949 flow to Schedule D, where the total capital gain or loss is calculated.

On the 8949, you need to enter a description of the property, the date acquired, date sold, proceeds, cost, and calculate the gain or loss. If you have a lot of sales to report, it could be extremely time consuming to enter all of this information for each transaction. Luckily, you can just report totals, instead of reporting each transaction individually. You can report the total for each brokerage account for each section of the 8949, and then attach a copy of your 1099-B to your tax return. If you report totals instead of individual transactions, you can put code "M" in column F of the 8949 to indicate that it is a summarizing transaction.


Wash Sales


There is a special tax rule that disallows losses from wash sales. A wash sale occurs when you purchase stock within a 30-day window around the sale date of selling substantially identical stock. This means that you cannot deduct a loss from a stock sale if the same stock is purchased again within 30 days of the sale. For example, suppose a trader sold 100 shares of XYZ on November 16 for $1,000. If the cost basis was $1,500, the trader has a loss of $500. If the trader repurchased XYZ again on December 8 (within 30 days) for $1,200, then the $500 loss would be considered a wash sale. On the tax return, the wash sale adjustment results in this loss not being deducted.


However, the wash sale adjustment is added to the stock’s basis so that it can be deducted in the future when this stock is sold again. This trader’s basis in XYZ would now be $1,700 ($1,200 cost basis + $500 wash sale adjustment). This rule only applies to losses, not gains. One way to avoid this rule is wait at least 31 days after selling a stock at a loss to repurchase it. Your broker will report any wash sales to you on your 1099-B in a separate column. You can report the wash sale adjustment on your 8949 in column G, with the code "W" in column F.

Capital Loss Limitation

Capital losses may or may not be deductible to offset your other income. There is a $3,000 limitation for capital losses, so if a trader loses more than $3,000 in a year, they won't be able to deduct all of those losses. However, the losses in excess of $3,000 will be carried forward indefinitely to be deducted in future years. For example, suppose a trader loses $5,000, and earns $50,000 from his job. His capital losses would be limited to only $3,000, so his taxable income would be $47,000. The remaining $2,000 of capital losses can be carried forward to the following year. If he has $6,000 of capital gains next year, the $2,000 loss carried forward would offset those gains, so his net capital gain next year would be $4,000.


60/40 Rule

One of the reasons I like to trade futures (besides the leverage and 24 hour liquidity) is something called the 60/40 rule. This rule means that certain investment products (called Section 1256 contracts) have a special tax treatment – gains and losses are treated as 60% long-term and 40% short-term, regardless of how long you actually hold the position. That means that if you made $1,000 from day trading futures, $600 of it will be taxed at the favorable long-term capital gains rate, and the other $400 will be taxed at your higher ordinary tax rate. In comparison, if you made the same $1,000 profit in stocks, it would be taxed entirely at the higher ordinary rate.

Because of this rule, futures gains and losses may be reported on a separate 1099-B. On your tax return, you report these gains and losses on Form 6781, rather than Form 8949. The 6781 walks you through the calculation to split the gain or loss between short-term and long-term.


Net Investment Tax


Earlier, I said that long-term capital gains are taxed at a maximum of 20%. However, that's not exactly true. There's an additional tax called net investment tax. Capital gains, interest, dividends, and other passive income are subject to this extra tax if a taxpayer's income is above $200,000 if single, or $250,000 if married. The net investment tax is 3.8%, so capital gains could actually be taxed at a rate of up to 23.8% (20% + 3.8%).


Disclaimer


None of the above should be considered tax advice. Everyone’s tax situation is unique, so please consult your tax advisor.


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