Top 10 Tax Deductions For Active Traders
By Robert A. Green, CPA, GreenTraderTax.com
Active traders qualifying for trader tax status (TTS) maximize these deductions in the following ways:
1. Home-office (HO) deductions
Use the square footage or rooms method to allocate every expense of your home including mortgage interest, real estate taxes, rent, utilities, repairs and maintenance, insurance and depreciation. The IRS limits use of HO expenses by requiring business income to offset the deduction, except for the mortgage interest and real estate tax portion. Link the HO Form 8829 to TTS trading gains or transfer some to Schedule C to unlock the HO deduction. If you have trading losses, carry over unallowed HO deductions to subsequent tax year(s). Converting personal home expenses to business use is great.
2. Additions and improvements to office
Consider an addition or improvements to your home office like building more space, replacing windows, walls, and flooring. Depreciate residential real property over 39 years on a straight-line basis. If you rent or own an outside office, depreciation rules are more attractive. The Protecting Americans From Tax Hikes (PATH) Act of 2015 created “qualified improvement property.” It’s a new class of nonresidential real property, excluding additions like increasing square footage. Use 50% bonus depreciation on qualified improvement property placed in service in 2016. PATH extended bonus depreciation through 2019.
3. Tangible property expensing
Expense new tangible property items up to $2,500 per item. Before 2015, the IRS threshold for capitalization with depreciation vs. full expensing was $500. When you purchase a new trading computer system its best to arrange separate invoices for each item not exceeding $2,500.
4. Section 179 (100%) depreciation
For equipment, furniture and fixtures above the tangible property threshold ($2,500), use Section 179 depreciation allowing 100% depreciation expense in the first year. PATH made permanent generous Section 179 limits. The 2016 limit is $500,000 on new and used equipment including off-the-shelf computer software. The IRS limits the use of Section 179 depreciation by requiring income to offset the deduction. Look to business trading gains, other business income or wages, from either spouse, if filing joint.
5. Automated trading systems
Increasingly, traders are writing computer code for developing automated trading systems. The IRS allows a few different choices for expensing “internal-use software.” If you qualify for TTS before incurring software development costs, deduct them like other research expenses in Section 174(a) in the year paid. If you don’t qualify for TTS before incurring software development costs, capitalize them under Section 174(b). Two choices: When you complete the software and qualify for TTS, amortize (expense) the intangible asset over 60 months. Or, wait until you place the software in service with qualification for TTS to amortize (expense) the intangible asset over 36 months. Traders may qualify for TTS using automated trading systems providing they write the code or have other significant involvement with creation and modification of the automated trading systems. Conversely, if a trader purchases an off-the-shelf automated trading system providing entry and exit signals and trade execution, the trader probably doesn’t get credit for the volume and frequency of trades made by the automated trading system.
6. Education, mentoring and seminars
All three are considered education expenses and tax deductibility hinges on qualification for TTS. Education business expenses paid after the start of your business are allowed for maintaining and improving your business. Learning a new business before starting that business is not allowed as a business expense. If you are learning about investing while carrying on an investment activity, that education expense is not allowed as a Section 212 investment expense by Section 274(h)(7). Tip: If you pay for trading education services before qualifying for TTS, consider using Section 195 start-up expenditures treatment below.
7. Section 195 start-up expenditures
Go back a reasonable period (six months) before qualifying for TTS to capitalize a reasonable amount ($15,000) of start-up costs. Start-up expenses include costs to investigate and inquire about a new business. Costs capitalized in Section 195 would have to qualify as a business expense if paid after business commencement. Section 195 allows an expense allowance in the first year up to $5,000. Start a calendar year business late in the year and still get the full $5,000 expense allowance. Amortize the remainder of the costs over 180 months on a straight-line basis. If you exit the trading business, you may write off the unamortized balance.
8. Organization costs
Under Section 248 for corporations and Section 709 for partnerships, treat expenses to organize or form an entity in a similar manner as Section 195 start-up expenditures. There is a separate first-year expense allowance up to $5,000, and the balance is amortizable over 180 months on a straight-line basis.
9. Health insurance premiums
Deduct health insurance premiums from individual AGI if you have an S-Corp trading company paying you W-2 wages, which include your premiums. The plan must be in association with your small business and not a third-party employer plan for you or your spouse. Deduct health insurance premiums during the entity period, not before. This S-Corp wage component for health insurance premiums is not subject to social security and Medicare taxes, so enjoy the income tax savings with no offsetting payroll tax costs. A C-Corp management company deducts health insurance premiums on the corporate tax return.
10. Retirement plans
Most traders with TTS should consider a Solo 401(k) retirement plan. Consistently high-income traders with TTS should consider a defined benefit plan if they are close to age 50. Retail traders need an entity like an S-Corp trading company or C-Corp management company to arrange retirement plan deductions since sole proprietor traders don’t have earned income required for employee benefit plan deductions. With one exception: Futures traders using full exchange membership have self-employment income (Section 1402i).
Solo 410(k) plan: S-Corp officer wages of $140,000 unlock the maximum $53,000 contribution/deduction or $59,000 if age 50 or older with the $6,000 catch-up provision. The 100%-deductible elective deferral up to $18,000, or $24,000 with the catch-up provision, provides the greatest income tax savings vs. payroll tax costs. The 25%-deductible profit-sharing plan up to $35,000 is good if you have sufficient cash flow to invest in tax-free compounded growth within the plan.
Defined-benefit plan (DBP): With consistent high trading income, arrange a $100,000 plus contribution/deduction with a defined-benefit plan. Work with an actuary on complex DBP calculations.
Business traders have a wide variety of other expenses including independent contractors and employees for trade assistance and IT, market data providers, charting software, chat rooms and trading groups, subscriptions, books, periodicals, attorneys, accountants, tax advisors and more.
Commissions are not expenses; they are part of the trading capital gain or loss.
Business expenses are deductible “above the line” from gross income, whereas investment expenses face significant limitations “below the line.” Section 212 investment expenses exclude home office, start-up expenditures, employee benefits and education. They are part of miscellaneous itemized deductions, which must first exceed a 2% of AGI threshold. Upper-income taxpayers face additional limitations: a Pease itemized deduction phase-out and AMT taxes since investment expenses are an AMT preference item.
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