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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.
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.
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.