For Tax Purposes, Can a Retiree be in the Business of Investing?

From Forbes.com

Some people spend enough time on their portfolios that they believe investing has become jobs or businesses.

There are tax advantages of being in the trade or business of investing, so the tax code limits who qualifies.

Retirees often earn most of their income from their investments. Interest, dividends, and capital gains pay the bulk of their expenses. Some retirees devote enough time and attention to their portfolios that they believe investing has become jobs or businesses. They ask, for tax purposes, can a retiree be in the business of investing?

There are tax benefits when investing is your trade or business, which the IRS calls being a trader. All your investment-related expenses are deducted directly from investment income on Schedule C. You might even be able to deduct home office expenses, computers, and office supplies. Unlike most Schedule C taxpayers, the net income from trading isn’t subject to self-employment tax. But a trader can’t deduct Keogh retirement plan contributions.

A trader also can elect to mark-to-market all investment positions at the end of each year. This means you report gains and losses as though you sold each position on the last day of the year, though you haven’t. If you have a net loss on paper at the end of the year, you have a net loss for tax purposes, though you haven’t sold your positions and today’s paper losses might turn into gains next year. Under this election, you also can deduct net losses against other income without being subject to the $3,000 annual limit other taxpayers face on capital loss deductions. A disadvantage of being a trader is you don’t receive the preferential long-term capital gains rate. All net gains and losses are ordinary income or losses.

These tax rules apply only if you’re a trader under the tax code. If you’re not a trader, you’re an investor and don’t receive any special tax treatment.

Because the tax advantages of being in the trade or business of investing can be significant, the IRS and courts tightly limit who qualifies as a trader.

Whether you’re an investor or trader depends on your time perspective, your goals, the type of income you earn, and the amount of transactions you engage in.

To be a trader, your investment activity must be substantial and must be carried on with regularity and continuity. You also must seek to profit primarily from daily (or more frequent) market movements and not primarily from interest, dividends, or long-term capital gains. The IRS will examine the amount of time you devote to investing and whether you are pursuing the activity for a livelihood. But the key factors are the frequency and dollar amount of your trades during the year and the typical holding period for a security.

You must pass all the tests to be considered a trader. There have been court cases in which taxpayers engaged in more than 200 trades per year but weren’t considered traders either because their trading wasn’t considered regular or continuous or because they weren’t trying to profit from daily market movements.

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