A new year has just begun, but the deadline to file for taxes could catch day traders unprepared. After spending a year trying to beat the market, the last thing any trader wants is to hand over more than is necessary to the IRS.
Day trading taxes can be very confusing, and for traders, filing day trading taxes can be a very time consuming process that often requires the help of a CPA. However, there are some basic rules that can help any trader understand day trading taxes.
What is a capital gains tax?
This is a tax that applies to the profit investors make from selling an asset. The capital gains tax can apply to anything ranging from the sale of antiques, real estate, and more, but for day traders, the capital gains tax is especially relevant since it applies to investments such as stocks, bonds, and cryptocurrency.
Long-Term vs. Short-Term Capital Gains
For new day traders and investors who are concerned about the day trading taxes on their investments, it’s important to note one significant difference in the way the capital gains tax is applied. The IRS differentiates between short-term and long-term investments, classifying those held for more than a year as long-term. These are taxed at a lower rate than the normal income rate applied to short-term investments.
For this reason, it’s recommended that traders maintain two separate accounts for their investments to make the process easier come tax day.
Day Trading Taxes
As long as you are a profitable day trader, you will face day trading taxes. This applies to any assets you bought and sold within the same year for a profit. To prepare, traders should set aside a portion of their earnings to help pay off any taxes they owe later on.
At the end of the fiscal year, any profits from your short-term investments will be added to your yearly income and will be taxed at the same rate as your income.
This means that the capital gains tax applied will depend on your tax bracket and filing status, ranging from 10% for a single filer with a gross annual income of up to $11,600 to 37% for gross incomes of more than $609,350. However, federal tax brackets change every year to reflect the rate of inflation, so look for the most updated information for each fiscal year.
| Filing Status | 10% | 12% | 22% | 24% | 32% | 35% | 37% |
|---|---|---|---|---|---|---|---|
| Single | Up to $11,600 | $11,600 – $47,150 | $47,150 – $100,525 | $100,525 – $191,950 | $191,950 – $243,725 | $243,725 – $609,350 | Over $609,350 |
| Head of Household | Up to $16,550 | $16,550 – $63,100 | $63,100 – $100,500 | $100,500 – $191,950 | $191,950 – $243,700 | $243,700 – $609,350 | Over $609,350 |
| Married Filing Jointly | Up to $23,200 | $23,200 – $94,300 | $94,300 – $201,050 | $201,050 – $383,900 | $383,900 – $487,450 | $487,450 – $731,200 | Over $731,200 |
| Married Filing Separately | Up to $11,600 | $11,600 – $47,150 | $47,150 – $100,525 | $100,525 – $191,950 | $191,950 – $243,725 | $243,725 – $365,600 | Over $365,600 |
Although the income thresholds determining these tax brackets could change, it’s important to understand how the brackets work relative to your effective tax rate. For example, even if your taxable income is $90,000 you would only pay 10% on the first $11,000 and then 12% on income from $11,000 to $44,725. After that you would pay 22% on income from $44,725 to $95,375 which means that only $45,275 of your income would be taxed at 22%.
So, even though you fall in the 22% tax bracket, your effective tax rate is just the total amount you paid in taxes divided by your taxable income. In this case, the effective tax rate is about 16.6%
Taxes on Long-term Investing
On the other hand, long-term investors who hold their shares for longer than a year will benefit from their patience. The tax on long-term capital gains generally ranges from 0% – 28%, depending on an individual’s taxable income and filing status. This means investors might be able to pocket more of their profits by investing for the long-term.
If your taxable income is less than or equal to $41,675 for single and married filing separately or $83,350 for married filing jointly, then some or all of your net capital gain could be taxed at 0%.
Typically, the capital gain tax is no more than 15% as long as your taxable income is between $41,675 and $459,750 for an individual filing alone and between $83,350 – $517,200 for married filing jointly. Any income exceeding $517,200 will face a net capital gain tax rate of 20%.
| Filing status | 0% | 15% | 20% |
| Single | $0 to $44,626. | $44,626 to $492,300. | $492,300 or more. |
| Married Filing Jointly | $0 to $89,250. | $89,251 to $553,850. | $553,850 or more. |
| Married Filing Separately | $0 to $44,625. | $44,625 to $276,900. | $276,900 or more. |
| Head of Household | $0 to $59,750. | $59,751 to $523,050. | $523,050 or more. |
Wash Sales
New traders might think that selling a position at the end of the year for a loss will help them reduce their day trading taxes. While you can receive a tax deduction if you report a loss from selling your position, it’s important to understand wash sales before trying to save on your day trading taxes.
Some of you may remember 2021’s story of an unnamed Robinhood trader who unwittingly incurred $800,000 in taxes. This individual was new to trading and started off with $30,000 in his account. He was able to triple that and transacted nearly $45 million in total trades throughout the year. While he made a profit of $45,000 by year’s end, he totaled $1.4 million in capital gain income for a total tax bill of $800,000.
This was because he did not understand wash sale rules which disallow tax deductions from selling at a loss. Ordinarily, selling your position at a loss would mean that you can deduct that loss against your capital gains. But, this was abused by traders who would repurchase their position soon after selling, because they still wanted a position in the same stock, so that the loss would be reflected in their taxes despite them potentially profiting off of the same position later on.
Because of these “Wash Sales”, the IRS instituted rules which state that you cannot claim a loss on securities if you purchase “substantially identical” ones within 31 days before or after the sale. The IRS views identical securities as both the stock and the option, so a wash sale can be triggered between stocks and options.
This applies across all your accounts across different brokerage platforms, including your spouse’s accounts. A wash sale can even be triggered if you repurchase the shares on a retirement account such as an IRA or Roth IRA account.
A Wash Sale Example
While wash sale rules may seem complicated, in practice they are not as bad as they might seem – especially if you held that position for a long time.
For example, if you buy $1,000 worth of NIO (NYSE: NIO) stock and a year later sell your shares for a loss of $300, then that loss would be reflected as a long-term loss. In cases of a very large loss, after the maximum deductible amount is made, the remainder can be carried forward to the following tax years until the total loss is completely paid off.
But if NIO drops even lower within 30 days from the sale and you think that this might be a good opportunity to get in again and decide to repurchase shares for a total of $500, you will trigger a wash sale as soon as you repurchase the shares.
This means the original loss of $300 would be disallowed as a deduction for that tax year and you won’t be able to get the tax benefit from it and instead the $300 would be added to the cost basis of the repurchased shares for a total of $800.
Then, when you sell your position for $1,000 later on, the taxable gains would only be $200 instead of $500 because of the original $300 loss. Because you held your original position in NIO for more than a year, it would also be treated as a long-term capital gain even if you held your new position for just a few months.
This is because wash sale rules say that the holding period of the old stock that you took the loss in must be added to the holding period of the replacement security. In the event that you end up selling your shares of NIO for a loss yet again, the higher cost basis would mean that you can claim a larger loss for deduction in that tax year.
In this way, there are some benefits to the wash sale rule but one major problem traders face is the definition of “substantially identical”. Since this is the exact phrase provided by the IRS, it’s difficult for retail traders to determine what meets this classification.
Following up on our NIO stock example, if you sold your NIO shares and took a loss but don’t want to repurchase it in order to avoid a wash sale, then you can instead invest in another EV like Tesla (NASDAQ: TSLA), and a wash sale won’t be triggered.
Some examples of how this definition is applied include:
| If You… | Within 30 Days You | Wash Sale Rules |
| Buy stock or call options & close for a loss | Rebuy stock or calls for the same ticker | Applied |
| Buy puts & close for a loss | Buy the stock, calls, or puts for the same ticker | Applied |
| Short stock & close for a loss | Buy/Sell stock, Buy/Sell calls, or buy/sell puts for the same ticker | Applied |
| Sell puts & close for a loss | Buy/Sell stock, Buy/Sell calls, or buy/sell puts for the same ticker | Applied |
| Sell calls & close for a loss | Buy/Sell stock, Buy/Sell calls, or buy/sell puts for the same ticker | Applied |
Wash Sale rules in December and January
Day traders will trigger wash sales throughout the regular course of trading, however, in December and January traders should pay close attention to wash sale rules because of the potential impact to their year end profit or loss.
It’s a common misconception that since the fiscal year ends in December, buying back the stock in January would not trigger a wash sale. In truth, this is not the case and traders should still wait a full 31 days before purchasing the same or a substantially similar position.
Your year end profit and loss would also be affected if you have positions open with accumulated wash sales and do not close them at the end of the tax year.
If you take a loss in December on a position, it’s recommended that you hold off on trading that stock for a full 31 days so that the loss is reflected for that tax year rather than deferred to the next.
However, this does not mean that day traders should stop trading for the entire month, instead you should just be mindful of what positions you have open, any losses you take, and whether or not there are accumulated wash sales on your positions.
But if you are considered a day trader according to the IRS, you can benefit from this classification when filing your taxes.
Trader Tax Status (TTS)
While some traders identify themselves as day traders, you should note that you have to meet certain conditions to be considered a day trader by the IRS. According to the IRS, you must actively seek to profit from daily price movements of securities. In general, this should be the goal of any trader, but qualifying for Trader Tax status becomes more difficult when you consider that more than 50% of your income must come from trading. This effectively weeds out those who might trade as a hobby rather than as an occupation.
You also should have business expenses customary to that of an active day trader. However, rather than an annoyance this can be an advantage because it allows you to write off expenses like computer equipment, office space, education, and even travel in some cases. Other examples of business expenses daytraders commonly incur could be subscriptions to platforms like Ortex or news services.
A good benchmark for knowing whether you qualify for Trader Tax Status is whether you take at least 720 trades throughout the year and have at least $25 thousand in trading account capital with a US broker.
The hardest qualification to meet is trading for at least 189 days. While the stock market is open 252 days per year, it can be better to sit out of a trade rather than force it, which means meeting this qualification may be more difficult than the others. It’s also important to note that even if you qualify for TTS one year, you might not the next.
Still, if you meet the qualifications, it’s well worth it. Qualifying for TTS can open up a number of opportunities for traders, one of which is Market-to-Market Election. Unfortunately, anyone who does not meet the qualifications for TTS are classified merely as investors and are ineligible for Mark-to-Market Election.
Mark-to-Market Election
Opting into Mark-to-Market election comes with a number of benefits because your gains from trading are no longer classified as capital gains and instead qualify as ordinary income. This allows traders to deduct losses beyond the $3,000 allowed as capital losses.
On top of this, it counts the total of your trading gains and losses as business property. As a result, you would be able to claim all of your 2023 losses when filing your 2023 taxes. You would also be exempted from the pesky wash sales rule. However, TTS traders must make a MTM election with the IRS prior to the April 18th deadline for 2024.
Also keep in mind that this election is forward-looking and looks at the future year, so even if you become a market-to-market trader, you can’t use that newly acquired position to deduct any losses prior to the election.
If you make this election, you would also be exempt from the wash sale rule. Despite the MTM election’s positives, the downside is that you have to sell all your holdings on the last trading day of the year and purchase them again once trading resumes in the new year to provide a total accounting of your assets each year.
Since those who are trading securities have to apply based on the previous year’s tax return, it’s hard to say whether or not it will benefit you in the following year.
Mark-to-market means you treat a trading position as closed at year-end and account for any gains or losses based on the market value.
The mark-to-market price is used against your cost basis to determine if you have a profit or loss on those positions.
However, if you want to realize only one of the losses, selling the stock you’ve owned for under a year is more advantageous, since the capital loss is figured at the higher short-term capital gains tax rate.
Compare that to an ordinary investor with $50,000 in earned income (taxable wages, for instance) and $20,000 in trading or investing losses; the investor can only deduct $3,000 of those losses, which leaves $47,000 in taxable income.
As a full-time trader with the mark-to-market election in place, if you have $50,000 in profits, you can write off all $20,000 of your losses, leaving you with only $30,000 in taxable income.
Conclusion
Any profitable day trader must pay day trading taxes on their gains, but active day traders can reduce their day trading taxes in a few different ways.
By taking advantage of the IRS system of deductions, you can lessen your tax burden, and by filing an election to mark-to-market, you can record losses over $3,000, reset your gains and losses yearly and be exempt from the wash sale rule.
In addition to these tax deductions, you can file for business-related tax deductions, such as the cost of your investing software or your internet bill. All of this added up could allow day traders to avoid or at least reduce the amount of capital gains tax they will have to pay.
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