Most taxpayers are classified as investors. Online investors are responsible for 37% of all retail stock trading. An investor is someone who buys and sells securities with the idea of realizing income in the form of interest, dividends and hopefully, capital gains from an appreciation in value over some period of time.
An investor’s investment activity usually is not his sole source, or even his main source, of income. It is generally a passive activity. On the other hand, an investor may maintain an office and incur substantial expenses for advice, financial information, on-line services, record keeping, etc. for the purposes of managing his large and active portfolio.
While an investor’s active management of the portfolio may result in his obtaining most of his income from the investments, this has no effect on changing him from his Investor Status. It is the character of the financial securities and financial instruments which he buys and the amount of selling activity that he engages in with respect to them that determines his tax status.
Example of an Investor Status taxpayer: A taxpayer’s principal daily activity consisted of buying at low prices the stock of companies in financial trouble which his thorough and time-consuming analysis indicated would likely be turned around, permitting him to eventually realize long-term gains. Despite the significant amount of time and effort devoted to this and the large amount of funds invested in the transactions, the Tax Court held that he was not a trader but was actually an investor. (Yaeger v. Comr.)
Definition of an Investor
The IRS FAQ site has said that: “Investors trade solely for their own account and do not carry on a trade or business. Their securities sales result in capital gain or loss and their deductible expenses are itemized deductions. Dealers sell securities to customers in the ordinary course of trade or business. Their sales result in ordinary gain or loss [generally subject to self-employment tax] and their deductible expenses are trade or business expenses. Traders buy and sell securities frequently but have no customers. Their purchases and sales result in capital gain and loss [generally not subject to self-employment tax, and optionally converted to ordinary gains and losses via electing to use the mark-to-market method of accounting], and their deductible expenses are trade or business expenses.”
“Even if you engage in extensive securities activities, you are an investor, not a dealer or trader, if you do not seek profit primarily in swings in daily market movements, and [sic OR you] do not personally engage in or direct the purchases or sales. An investor trades for profit-motivated reasons such as long-term appreciation, dividends and interest. Whether the activities of an individual constitute trade or business or investment is determined from the facts in each case. These distinctions have been established through court cases.”
According to a Roper Starch survey online investors can be defined as:
- Online investors buy or sell stocks slightly more than once a month on average, and more than 80% of online investors have a defined investment strategy.
- The more common strategy is investing for long-term capital growth; online investors tend to buy stocks and hold them.
- Online investors spend a day or more on average making their investment decisions and use research tools such as analyst reports, earnings reports, and news.
- Nearly eight of every ten online investors in the survey say they are somewhat to very satisfied with the success of their online investment performance.
An individual investor’s expenses relating to his portfolio are usually partially deductible under IRC §212 as itemized deductions (federal Form 1040, schedule A, line 23) limited by the 2% adjusted gross income floor on miscellaneous deductions and by the 3% limitation for higher income taxpayers (other than certain deductible payments made with respect to short sales). Investment interest (federal Form 1040, schedule A, line 14) is also not subject to the 2% floor limitation but is deductible only to the extent of net investment income (normally interest & certain dividends and optionally capital gains).
The expenses are deductible only if (1) they are paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income; and (2) they are ordinary and necessary under all the circumstances, having regard to the type of investment and to the relation of the taxpayer to such investment.
AN INVESTOR’S TAX DEDUCTIONS:
- tax advice including, for example, fees paid to TraderStatus.com™
- investment counsel
- subscriptions to financial magazines and newspapers
- investor guides and books
- custodial fees
- dedicated telephone usage and long distance
- cell phone, pager and messenger fees
- wireless trading fees
- cable fees
- on-line services and connection fees
- real-time quotes, charting and analysis
- stock tip services & newsletters and news service fees
- investor chat room fees or subscriptions
- office rent (but not if paid to yourself)
- office supplies, postage, bank charges and wire fees
- clerical and record keeping expenses
- wages paid to your spouse, kids, or parents for their assistance
- deductible retirement plans, including the Single-Participant 401k on those wages (click here for more) (if the business is properly designed)
- a non-deductible Roth IRA in lieu of a regularly deductible IRA (to the extent there is some applicable “earned income”)
- interest paid on loans for the purchase of the investor’s positions (partially deductible as “investment interest” on IRS Form 4952)
- depreciation on furniture, computer equipment and software
- ○ computers & equipment 5 year life (Rev Proc 87-56)
- ○ office furniture & fixtures 7 year life (Rev Proc 87-56)
- travel and automobile expense primarily to protect the value of the investment
- 50% deductible restaurant meals had with friends who are fellow investors, lawyers, bankers, advisors
- entertainment with and gifts to friends who are fellow investors, lawyers, bankers, advisors
- charitable contributions
Optionally, pursuant to Code Section 266 and IRS Regulations 1.266-1 an investor may choose, annually, to file a written election to capitalize, rather than deduct, property taxes, mortgage interest, insurance expenses, and other miscellaneous carrying costs.
- raw land §1.266-1(b)(1)(i)
- real estate §1.266-1(b)(1)(ii)
- personal property §1.266-1(b)(1)(iii)
- other property §1.266-1(b)(1)(iv)
But note that IRS Chief Counsel CCA200721015, in 2007 wrote that under IRS Regs §1.266-1(b)(1)(iv) a flat fee paid to a stockbroker for investment services is an itemized deduction and is not a “carrying charge.”
WHAT’S NOT DEDUCTIBLE BY INVESTORS?
- Commissions paid to your brokers are capitalized and applied to reduce capital gain or increase capital loss when you sell the stock.
- Fees charged by your bank for check writing
- Convention, seminar, or similar meeting on investments and investing strategies (see IRC §274(h)(7))
- Expenses of attending a stockholders’ meetings, even if you own stock in the company and the meeting would be useful toward making further investments
- Any expenses you incur toward generating investment income that is exempt from taxes (e.g., municipal bonds, etc.)
Limits on Deductions
Your deductions for investment expenses may be limited by:
- The at-risk rules,
- The passive activity loss limits,
- The limit on investment interest, or
- The 2% limit on certain miscellaneous itemized deductions.
The at-risk rules and passive activity rules are explained briefly in this section. The limit on investment interest is explained later in this chapter under Interest Expenses. The 2% limit is explained later in this chapter under Expenses of Producing Income.
At-risk rules. Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Generally, this is the amount of cash and the adjusted basis of property you contribute to the activity. It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. For more information, see Publication 925.
Passive activity losses and credits. The amount of losses and tax credits you can claim from passive activities is limited. Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.
Passive activity. A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.
- More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate.
- You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.
The term “trade or business” generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, it does not include rental activities or certain activities treated as incidental to holding property for investment.
You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.
Other income (nonpassive income). Generally, you can use losses from passive activities only to offset income from passive activities. You generally cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. This includes capital gain distributions from mutual funds and real estate investment trusts.
You cannot use passive activity losses to offset Alaska Permanent Fund dividends.
Expenses. Do not include in the computation of your passive activity income or loss:
- Expenses (other than interest) that are clearly and directly allocable to your portfolio income, or
- Interest expense properly allocable to portfolio income.
However, this interest and other expenses may be subject to other limits. These limits are explained in the rest of this chapter.
Additional information. For more information about determining and reporting income and losses from passive activities, see IRS Publication 925.
Final comment: The same taxpayer could be considered both an investor with respect to a portion of his activities, and a trader or dealer with respect to another portion. For IRS tax purposes, however, the person’s status is usually determined based on his overall activity unless there is carefully documented segregation of the activities.
Here at TraderStatus.com we often use a specially designed pure-play trader entity that files its own separately tax return, which generally eliminates this potential problem of segregation of the activities.