Most of the expenses incurred by investors related to their investing activity are deductible as miscellaneous itemized deductions.These expenses may include subscription publications and services, fees for investment advice, office-related expenses, and other costs. Miscellaneous itemized deductions are less valuable than other kinds of itemized deductions or business deductions for two primary reasons: i) miscellaneous itemized deductions are not deductible for purposes of computing the alternative minimum tax; and ii) for purposes of computing the regular income tax, they are deductible only to the extent they exceed 2% of the taxpayer’s adjusted gross income.
Investors who engage in high-volume trading of stocks and other securities sometimes take the position that they are engaged in a “trade or business” of trading securities. If this position is correct, all their related expenses are deductible as business deductions and not subject to the above limits.
The IRS and the courts take a very strict view of what is required to be engaged in a trade or business as a trader of securities. The taxpayer must engage in a very high volume of trades, must seek to profit from daily or short-term price movements rather than long-term growth, and must engage in trading activity on most days on which the markets are open.
In Nelson v. Commissioner (November 13, 2013), the Tax Court determined that the taxpayer’s trading activity was not sufficient to meet the requirements in two different tax years. The taxpayer completed 535 trades in 2005, and 235 trades in 2006. In 2005, the taxpayer traded on 121 out of the 250 days on which markets were open, and in 2006 she traded on 66 out of 250 possible trading days. The court also noted that a significant number of the total trades occurred in a short period and that there were long periods during which no trading occurred.
In other cases where taxpayers have prevailed on this issue, the court found that 1,543 trades in a year and 1,136 trades in a year were substantial.A person seeking to establish that he or she is engaged in a trade or business of trading securities should plan to execute substantially more than 1,000 trades per year and also engage in trading activities on a substantial majority of all days on which the markets are open, with no long gaps with little or no trading activity. Trades should be closed the same day or within a short period. It may also be helpful to keep a daily written record of the time spent trading and researching securities to trade.