Although investors and traders both attempt to make profits in the financial market, their approach is rather different. A professional trader is someone who buys and sells securities frequently for short-term benefits. An investor generally buys and sells securities for long term capital gains and dividends. Investors hold on to their investments (shares, hedge funds, equity) for a longer duration in hopes of gaining larger returns.
In this article, we take a look at the advantages and disadvantages of both investing and trading.
There are four main facts and circumstances that need to be considered to determine if one is a professional trader or an investor.
- Typical holding periods for securities bought and sold.
- The frequency and dollar amount of your trades during the year.
- The extent to which you pursue the activity to produce income for a living.
- The amount of time you devote to the activity.
Advantages and disadvantages of a professional trading status:
A professional trader is treated as a business, and has the following main advantages:
- Traders can claim ordinary and necessary business expenses related to running the business such as software, computer equipment, advisory fees, etc. This results in a reduction of net income.
- A trader can claim the net loss as an ordinary loss not subject to the $3,000 limitation for investors, in case losses are more than gains.
- Traders do not have to worry about wash sales rules, which prohibit people from claiming losses on shares and securities sold for a loss but bought back within 30 days.
- One can use the trading income to contribute to a retirement plan.
- Income is not subject to additional Medicare tax on investment.
Here are some of the main professional trader disadvantages:
- Income is subject to the highest marginal tax rate of the trader, and no reduced long-term capital gains rates can be claimed.
- Income from professional trading is subject to social security and Medicare taxes.
- Cannot reinvest income into opportunity zones and defer taxes on the income.
Advantages and disadvantages of an investor status:
An investor is not treated as a business, and has the following main advantages:
- Long term capital gains, futures, and qualified dividends are subject to a reduced tax rate.
- Income is not subject to social security and Medicare taxes.
- Can reinvest gains in opportunity zones and defer taxes on those gains.
The main disadvantages for an investor include:
- Net losses are limited to $3,000 per year, but the used balance can be carried over to future years.
- No business deductions are allowed, and even the miscellaneous expense deduction for advisory fees was eliminated with the 2017 Tax Cuts and Jobs Act.
- Investors are subject to wash sales rules, where certain losses are suspended.
- Cannot use this income as active income for retirement plan contribution.
- Income is subject to additional Medicare tax on investment.
The main point to keep in mind:
To be considered a trader, you must meet all of the following conditions:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
- Your activity must be substantial.
- You must carry on the activity with continuity and regularity.
Even if you call yourself a trader, it does not mean that you are. If you do not meet all of the conditions above, you can still be considered an investor.
Whether you are an investor or a professional trader, you will still need to file tax returns. As tax rates differ for both categories, professional advice and assistance are necessary to determine your status in trading.
Speak to us today, so that we can help you file taxes in the proper status that you qualify for.