Green’s 2021 Trader Tax Guide: Highlights

Green’s 2021 Trader Tax Guide covers the 2017 Tax Cuts and Jobs Act (TCJA) and the 2020 Coronavirus Aid, Relief, and Economic Security (CARES) Act’s impact on investors, traders, and investment managers.

The highlights of this year’s guide are included below.

TAX CUTS AND JOBS ACT

Tax Cuts and Jobs Act (TCJA) was enacted on Dec. 22, 2017, and the law changes took effect in the 2018 tax year.

Like many small business owners, traders eligible for trader tax status (TTS) restructured their business to take advantage of TCJA. Two tax changes caught their eye: The 20% deduction on qualified business income (QBI) in pass-through entities, and suspended investment fees and expenses, which makes TTS even more crucial. (TCJA continues to allow itemized deductions for investment-interest expenses.) 

TCJA didn’t change trader tax matters, including business expense treatment, Section 475 MTM ordinary gain or loss treatment, and wash-sale loss adjustments on securities; it didn’t change TTS S-Corps’, Solo 401(k) retirement contributions and health-insurance deductions, either. TCJA also retains the lower Section 1256 60/40 capital gains tax rates; the Section 1256 loss carryback election; Section 988 forex ordinary gain or loss; and tax treatment on financial products including options, ETFs, ETNs, swaps, precious metals, and more.

CORONAVIRUS AID, RELIEF, AND ECONOMIC SECURITY ACT 

The 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES) overrode TCJA’s limitations on tax losses. CARES suspended TCJA’s “excess business loss” limitation for 2018, 2019, and 2020. CARES also provided for five-year NOL carrybacks, whereas TCJA suspended NOL carrybacks. Traders with trader tax status and Section 475 ordinary loss treatment consider NOL carrybacks for 2018, 2019, and 2020. Learn more about CARES’ impact on traders in Chapter 18.

BUSINESS TRADERS FARE BETTER

By default, the IRS lumps all traders into “investor tax status,” and investors get penalized in the tax code — more so with TCJA. Investors have restricted investment interest expense deductions, and investment fees and expenses are suspended. Investors have capital-loss limitations against ordinary income ($3,000 per year), and wash-sale loss deferrals; they do not have the Section 475 MTM election option or health insurance and retirement plan deduction strategies. Investors benefit from lower long-term capital gains rates (0%, 15%, and 20%) on positions held for 12 months or more before sale. If active traders have segregated long-term investment positions, this is available to them as well.

Business traders eligible for TTS are entitled to many tax breaks. A sole proprietor (individual) TTS trader deducts business expenses, startup costs, and home office expenses, and is entitled to elect Section 475 MTM ordinary gain or loss treatment. However, to deduct health insurance and retirement plan contributions, a TTS trader needs an S-Corp to create earned income with officer compensation. 

Don’t confuse TTS with the related tax-treatment election of Section 475 MTM accounting. The 475 election converts new capital gains and losses into business ordinary gains and losses, avoiding the $3,000 capital loss limitation. Only qualified business traders may use Section 475 MTM; investors may not. Section 475 trades are also exempt from wash-sale loss adjustments. The 20% deduction on qualified business income includes Section 475 ordinary income but excludes capital gains, interest, and dividend income. The QBI deduction for TTS/475 traders is subject to a taxable income threshold and cap. 

A business trader can assess and claim TTS after year-end and even going back three open tax years. But business traders may only use Section 475 MTM if they filed an election on time, either by April 15 of the current year (July 15, 2020, for 2020, with three-month postponement under CARES) or within 75 days of inception of a new taxpayer (i.e., a new entity). For more on TTS, see Chapter 1.

CAN TRADERS DEDUCT TRADING LOSSES?

Deducting trading losses depends on the instrument traded, the trader’s tax status, and various elections. 

Many traders bought this guide hoping to find a way to deduct their 2020 trading losses. Maybe they qualify for TTS, but that only gives them the right to deduct trading business expenses. 

Securities, Section 1256 contracts, ETNs, and cryptocurrency trading receive capital gain/loss treatment by default. If a TTS trader did not file a Section 475 election on securities and/or commodities on time (i.e., by July 15, 2020, or April 15, 2021, for 2021), or have Section 475 from a prior year, he is stuck with capital loss treatment on securities and Section 1256 contracts. Section 475 does not apply to ETN prepaid forward contracts, which are not securities, or cryptocurrencies, which are intangible property. 

Capital losses offset capital gains without limitation, whether short-term or long-term, but a net capital loss on Schedule D is limited to $3,000 per year against other income. Excess capital losses are carried over to the subsequent tax year(s). 

Once taxpayers get in the capital loss carryover trap, a problem they often face is how to use up the carryover in the following year(s). If a taxpayer elects Section 475 by April 15, 2021, the 2021 TTS trading gains will be ordinary rather than capital. Remember, only capital gains can offset capital loss carryovers. That creates a predicament addressed in Chapter 2 on Section 475 MTM. Once a trader has a capital loss carryover hole, she needs a capital gains ladder to climb out of it and a Section 475 election to prevent digging an even bigger one. The IRS allows revocation of Section 475 elections if a Section 475 trader later decides she wants capital gain/loss treatment again. 

Traders with capital losses from Section 1256 contracts (such as futures) may be in luck if they had gains in Section 1256 contracts in the prior three tax years. On the top of Form 6781, traders can file a Section 1256 loss carryback election. This allows taxpayers to offset their current-year losses against prior-year 1256 gains to receive a refund of taxes paid in prior years. Business traders may elect Section 475 MTM on Section 1256 contracts, but most elect it on securities only so they can retain the lower 60/40 capital gains tax rates on Section 1256 gains, where 60% is considered a long-term capital gain, even on day trades. The other 40% fall under ordinary income rates.

Taxpayers with losses trading forex contracts in the off-exchange Interbank market may be in luck. By default, Section 988 for forex transactions receives ordinary gain or loss treatment, which means the capital-loss limitation doesn’t apply. However, without TTS, the forex loss isn’t a business loss and therefore can’t be included in a net operating loss (NOL) calculation — potentially making it a wasted loss since it also can’t be added to the capital loss carryover. If the taxpayer has another source of taxable income, the forex ordinary loss offsets it; the concern is when there is negative taxable income. Forex traders can file a contemporaneous “capital gains and losses” election in their books and records to opt out of Section 988, which is wise when capital loss carryovers exist. (Contemporaneous means in advance — not after the fact using hindsight.) In some cases, this election qualifies for Section 1256(g) lower 60/40 capital gains tax rates on major currency pairs.

A TTS trader using Section 475 on securities has ordinary loss treatment, which avoids wash-sale loss adjustments and the $3,000 capital loss limitation. Section 475 ordinary losses offset income of any kind. 

The CARES Act allows taxpayers to submit five-year NOL carryback refund claims for the tax years 2018, 2019, and 2020 (i.e., a 2020 NOL carries back to 2015). Or taxpayers may choose to carry the NOL forward. TCJA tax-loss limitation provisions will apply again in 2021, allowing only NOL carryforwards used against 80% of the subsequent year’s taxable income. 

TCJA’s “excess business loss” (EBL) limitation also returns in 2021: $500,000 married and $250,000 other taxpayers (2018 limits). In 2021, taxpayers may add an EBL to a NOL carryforward. CARES suspended EBL rules for 2018, 2019, and 2020. See TCJA changes in Chapter 17 and CARES changes in Chapter 18.

TAX TREATMENT ON FINANCIAL PRODUCTS

There are complexities in sorting through different tax-treatment rules and tax rates. It’s often hard to tell what falls into each category. To help our readers with this, we cover the many trading instruments and their tax treatment in Chapter 3. Here’s a brief breakdown.

Securities have realized gain and loss treatment and are subject to wash-sale rules and the $3,000 per year capital loss limitation on individual tax returns. 

Section 1256 contracts — including regulated futures contracts on U.S. commodities exchanges — are marked to market by default, so there are no wash-sale adjustments, and they receive lower 60/40 capital gains tax rates. 

Options have a wide range of tax treatment. An option is a derivative of an underlying financial instrument and the tax treatment is generally the same. Equity options are taxed the same as equities, which are securities. Index options are derivatives of indexes, and broad-based indexes (stock index futures) are Section 1256 contracts. Simple and complex equity option trades have special tax rules on holding period, adjustments, and more. 

Forex receives ordinary gain or loss treatment on realized trades (including rollovers), unless a contemporaneous capital gains election is filed. In some cases, lower 60/40 capital gains tax rates on majors may apply under Section 1256(g). 

Physical precious metals are collectibles; if these capital assets are held for more than one year, sales are subject to the collectibles capital gains rate capped at 28%. 

Cryptocurrencies are intangible property taxed like securities on Form 8949, but wash-sale loss and Section 475 rules do not apply because they are not securities.

Foreign futures are taxed like securities unless the IRS issues a revenue ruling allowing Section 1256 tax benefits. 

Several brokerage firms classify options on exchange-traded notes (ETNs) and exchange-traded funds (ETFs) structured as publicly traded partnerships as “equity options” taxed as securities. There is substantial authority to treat these CBOE-listed options as “non-equity options” eligible for Section 1256 contract treatment. Volatility ETNs have special tax treatment: ETNs structured as prepaid forward contracts are not securities, whereas, ETNs structured as debt instruments are. 

Don’t solely rely on broker 1099-Bs: There are opportunities to switch to lower 60/40 tax capital gains rates in Section 1256, use Section 475 ordinary loss treatment if elected on time, and report wash-sale losses differently. Vital 2021 tax elections need to be made on time. See Chapter 3. 

ENTITIES FOR TRADERS

Entities can solidify TTS, unlock health insurance and retirement plan deductions, gain flexibility with a Section 475 election or revocation, prevent wash-sale losses with individual and IRA accounts, and enhance a QBI deduction on Section 475 income less trading expenses. An entity return consolidates trading activity on a pass-through tax return, making life easier for traders, accountants, and the IRS. Trading in an entity allows individually held investments to be separate from business trading. It operates as a separate taxpayer yet is inexpensive and straightforward to set up and manage. 

An LLC with S-Corp election is generally the best choice for a single or married couple seeking health insurance and retirement plan deductions. See Chapter 7.

RETIREMENT PLANS FOR TRADERS 

Annual tax-deductible contributions up to $63,500 for 2020 and $64,500 for 2021 to a TTS S-Corp Solo 401(k) retirement plan generally save traders significantly more in income taxes when compared to the costs of payroll taxes (FICA and Medicare). Trading gains aren’t earned income, so traders use an S-Corp to pay officer compensation. 

There’s also an option for a Solo 401(k) Roth for the elective-deferral portion only: If you are willing to forgo the tax deduction, you’ll enjoy permanent tax-free status on contributions and growth within the plan. See Chapter 8. 

20% DEDUCTION ON QUALIFIED BUSINESS INCOME

TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could be eligible for a 20% deduction on qualified business income (QBI). 

Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $426,600/$213,300 (married/other taxpayers) for 2020, and $429,800/$214,900 (married/other taxpayers) for 2021. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers). The W-2 wage and property basis limitations also apply within the phase-out range. Investment managers are specified service activities, too. 

QBI for traders includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income. 

TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $326,600/$163,300 (married/other taxpayers) for 2020, and $329,800/$164,900 (married/other taxpayers) for 2020. The IRS adjusts the annual TI threshold for inflation each year. 

Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap. For more information, see Chapter 7 and Chapter 17.

AFFORDABLE CARE ACT

TCJA and CARES did not change the Affordable Care Act’s (ACA) 3.8% Medicare tax on unearned income. The net investment tax (NIT) applies on net investment income (NII) for individual taxpayers with modified AGI over $250,000 (married) and $200,000 (single). The threshold is not indexed for inflation. Traders can reduce NIT by deducting TTS trading expenses, including salaries paid to them and their spouses. Traders may also reduce NII with investment expenses that are allowed on Schedule A, such as investment-interest expense. Investment fees and other investment expenses suspended from Schedule A also are not deductible for NII.

ACA’s individual health insurance mandate and shared responsibility fee for non-compliance, exchange subsidies, and premium tax credits continue to apply for 2020 and 2021. However, TCJA reduced the shared responsibility fee to $0 starting in 2019. 

For more information, see Chapter 9 and Chapter 15.

INVESTMENT MANAGEMENT CARRIED INTEREST

TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) from one year to three years. If the manager also invests capital in the partnership, she has LTCG on that interest after one year. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year.

Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities for more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.

Investors also benefit from carried interest in investment partnerships. TCJA suspended investment fees and expenses. Separately managed account investors are out of luck as investors pay investment fees, but hedge fund investors can limit the negative impact by using carried-interest tax breaks. The carried interest reduces a hedge fund investor’s capital gains instead of having a suspended incentive fee deduction.

INTERNATIONAL TAX MATTERS 

When it comes to global tax matters, we focus on the following types of traders: U.S. residents living abroad, U.S. residents with international investments, U.S. residents moving to U.S. territories like Puerto Rico (with substantial tax breaks), U.S. residents surrendering citizenship or green cards, and nonresident aliens investing in the U.S. with individual U.S. brokerage accounts or through an entity. See Chapter 14.