Another Reason Not to Day Trade

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Ever dreamed of being a professional stock trader? While the allure of easy money tempts many investors toward the dark side of day trading, making a bundle on the market's ups and downs is not as easy as it looks. And for those hoping to turn their investing activities into a sideline business, complete with tax write-offs, the IRS suggests you take a close look before filing your return -- or suffer the consequences.

Why day trade?
When buy-and-hold investing is suffering through a bear market, the temptation of day trading grows stronger. With shares trading at cheap prices, it seems that you simply need to pick off a few pennies on Circuit City (NYSE: CC  ) or Rite Aid (NYSE: RAD  ) on a regular basis to achieve a big payoff over time.

That's easy to do when a company like Google (Nasdaq: GOOG  ) rises from $85 a share at the IPO to more than $700 a pop by the end of last year. But it's a little more challenging with a company like Advanced Micro Devices (NYSE: AMD  ) , which went from $40 in 2006 to less than $5 a stub last month.

No deduction
The temptation to trade professionally has yet another problem, too: the tax collector. With the Internet making trading stocks from your bedroom as easy as turning on the TV, and deep discount brokerages eliminating many of the friction costs, you might think you could turn it into a business.

One Florida couple sought to do exactly that. After making $280,000 in income in 1999 and 2000, they decided to go pro. In 2001, they formed a company and made more than 660 trades over the course of two years. Not surprisingly, they suffered losses during the bear market -- losses they tried to claim as regular business losses.

Not so fast, said the IRS. While hundreds of trades a year might seem like a lot, the IRS didn't think so. It has two tests to determine eligibility: Was the couple's trading activity "substantial"? And were they trying to catch "swings in the daily market movements" in an attempt to profit from these short-term changes?

For the Florida couple, the Tax Court found that the answer to both questions was no. All of the deductions they wanted to itemize as business losses became capital losses instead, resulting in a tax bill of $98,000.

Stay long-term
This decision shows that short-term trading isn't the smartest way to save taxes. Day traders give up any chance of low tax rates on long-term capital gains. And even professional traders, who can write off certain losses, typically have to mark their gains to market every year -- giving up the tax deferral that long-term holders of stocks enjoy.

More importantly, day traders often miss out on truly big price moves. It took a decade, from 1998 through 2007, for Hansen Natural (Nasdaq: HANS  ) to return nearly 20,000%, or Apple (Nasdaq: AAPL  ) nearly 6,000% -- all with tax consequences deferred for those who held on.

Resist the siren song of the successful day trader. For every success, there are countless failures -- and while the IRS cometh for all, it'll take a much smaller bite out of long-term investors.

Google is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters services free for 30 days.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 14, 2009, at 3:58 AM, itrademax wrote:

    new features of TradeMax include

    Neutral Trend TradeMax is a full featured Vista style trade software specifically designed for active traders and investors to manage their trade data, optimize their gain/loss strategy, and prepare their Schedule D or Mark-to-Market Form(4797).

    The new features of TradeMax include

    1.) Track your trades: You can setup different investment type accounts among whole family and manage trade data over years. TradeMax tracks and categorizes trade data and security price automatically. You can view all investment accounts in one place.

    2.) Comprehensive Corporate Events Module : Recording various corporate events, such as stock splits, stock merge, spinoff and symbol changes

    3.) Powerful importing module: TradeMax has pre-defined profiles support most brokers. TradeMax also provides a flexible format reorganization algorithm which allows you to customize your own format.

    4.) Intelligent Option Cost Basis Adjustment Function: Auto- detecting Assigned, exercised and expired option, also defers cost to corresponding shares with its Option Adjustment function.

    5.) Handle Wash Sales: TradeMax calculates various Wash Sale scenarios, include but are not limited to, Wash Sale between identical securities (stocks and options), Wash Sales on an unequal number of securities and Wash Sales on Same Day Rule.

    6.) Simplify tax preparation: TradeMax can assign short trades and convert short / long position, and calculates Wash Sales automatically. You can generate Capital gains/losses report for Schedule D purpose or export *.txf file to popular tax software such as TaxCut, TurboTax.

    7.) Analyze your trading performance: You can analyze your trading performance easily with the help of WashSales Detail Report,Summary Report, Transaction Report and Daily Market Value Report.

    8.) Powerful Forex Rate Module:Auto-convert the transactions under Non-USD currency into USD figures.

  • Report this Comment On March 28, 2010, at 11:36 AM, chrissy1958 wrote:

    i have been day trading with much success in the past 2 months. for me it is great income and if you use the right stocks i havent lost anything. my question is when i file taxes at the end of the year will i pay based on the income i make from day trading or are there other taxes involved than just normal incme? also, can i write off the commisions that i pay? thanks..chrissy1958

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