Investing has become more accessible to more people than ever before due to the elimination of trading fees, the ability to purchase fractional shares of a stock, and the user-friendliness of investing apps. Investing in the stock market is one of the few ways to build meaningful wealth, so getting more people to participate in the stock market is overall a good thing. However, there are very serious consequences for newer investors who don’t know what they don’t know. Tax surprises from investing are becoming more frequent and more significant.

Tragic Story of RobinHood Investor – Tax Surprise From Investing

A 22 year old investor who used the RobinHood app for investing in 2020 was surprised to find out that he had a $800,000 federal tax liability when he prepared his tax return with TurboTax. His net profit for the year was $45,000 and he had no other income. He started investing with $30,000 in cash and he used a margin account, which is the default account type on RobinHood. How did this happen? He had $45 million in trades during the year, frequently moving in and out of the same stocks. He had never heard of the wash sales rules. He is now in negotiation with the IRS on how to handle his tax liability. Unfortunately, he is not alone and the there are many other new investors with tax surprises from investing.

Frequent Trading May Result in Wash Sales

What the heck is a wash sale, you may ask. If you an investor and you are buying and selling securities, you’ll want to become familiar with wash sales. The wash sale rule prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after a sale. If you do have a wash sale, then come income tax time, you will not be allowed to write off the investment loss. However, you still need to recognize all the gains you have from securities sales.

When tax time comes around, both the investor and the the IRS will receive Form 1099-B from the firm where the investor did the trading. The details of the trades for the year will be on Form 1099-B, including those trades which are wash sales.

The IRS makes a distinction between an investor, a trader, a dealer and had different tax rules for all three. In addition, a trader is also entitled to make an IRS Section 475(f) election to use mark-to-market rules. Therefore, there are four different types of tax treatment for taxpayers who buy and sell securities. Because the tax treatments are so different from each other, it’s important to understand which set of rules apply when you buy and sell securities. The potential impact on the taxpayer’s tax liability is significant for each election. In 2010, a CPA was found negligent and required to pay a $2.5 million settlement to a former client because the CPA did not inform the client of the Sections 457(f) election which would have reduced the client’s tax liability from trading securities.

Mark-to-Market Regulations

But don’t professional traders frequently buy and sell the same securities and run afoul of the wash sale rules? Professional traders have different rules which apply to them and they are not subject to the wash sale rules. Instead, they use a mark-to-market election. Under mark-to-market rules, dealers and eligible traders are treated as having sold all their securities on the last day of the tax year at their fair market value for income tax purposes. This causes any gain or loss to be taken into account over the year, netting the interim gains and losses together. Any gain or loss recognized under this rule is taxed as ordinary income or ordinary loss. Dealers’ and traders’ expenses are considered business expenses and are deductible subject to business expense deduction rules.

There are further distinctions between investors, dealers, traders and traders who have made the 475(f) election which are detailed here. However, it’s not easy for an investor, even one who trades very frequently like our RobinHood investor, to be considered a trader eligible for the 475(f) election so that he/she can use the mark-to-market rules. It is a distintion which is closely watched by the IRS and unfortunately the IRS Code does not provide a clear cut way to make the distinction. The courts have had to step in to decide when taxpayers are considered an investor or a trader, and the court cases have given conflicting results. There isn’t a clear cut frequency or quantity of trades to make the distinction. It appears to be more based on the individual’s intent for the trading to be a business, the frequency or regularity of trades is importan,t and the nature of the income derived from trading is important. Income which is derived from frequent, short-term trades which are timed to try to take advantage of market movements is more likely to result in a determination of a trader instead of an investor.

IRS Section 457(f) Election 

An IRS Section 457(f) election allows a trader to use the mark-to-market rules and be exempt from the wash sale rules. Dealers automatically receive 457(f) election status. The election must be made by the due date for the tax return for the tax year immediately preceding the election year, therefore the election must be made prior to the year the trades will receive 457(f) status and cannot be made after the fact. However, If filing for 457(f) status is overlooked, there is the possibility for a election later in the tax year with an reasonable explanation for the delay.

Capital Gains and Ordinary Income

There are generally two type of income for tax purposes, capital gains and ordinary income. The most common type of income is income you would get from working, or from dividends or interest income. The most common type of capital gain is when you sell an asset for more than you paid for it when you purchased it. Capital gains are currently taxed at a lower rate than ordinary income, providing a tax advantage.

In order to receive preferential tax treatment for a capital gain, you usually need to hold the asset for a year or longer. If you sell it in a shorter time frame, then the gain is taxed at ordinary income rates. Many new investors are trading securities frequently and aren’t aware of the capital gains rules. To prevent tax surprises from investing, investors should purchase securities they plan to hold for more than one year. If the securites have a loss, the investor should try to hold on to it for more than one year if possible so that the loss will be considered a capital loss.

Tax Losses Resulting In Tax Surprises From Investing:

A loss on an investment sale can be used to offset a gain on an investment sale for tax purposes, unless of course it’s a wash sale. If the recognized loss hasn’t been completely offset by the recognized gains, then up to $3,000 of the loss can be used to offset ordinary income. If there are still remaining recognized losses, in some cases the remaining loss can be carried forward to offset future year’s realized investment gains. It’s important to keep accurate tax records from year to year to be sure the losses are carried forward correctly. These may be positive tax surprises from investing, and you want to be sure to use them to your advantage if you are entitled to them.

For investment education, the Fidelity website has plenty of helpful information. If you want a more structured approach, Next Generation Personal Finance has on-line courses to learn more about investing and personal finance topics and a free on-line resource to learn more about investing from the agency which regulates the investment industry, FINRA, is here.

As always, if you would like more information on investments or any other financial planning topic, please contact me. Find out more about Access Financial Planning, LLC here

Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.