The average American taxpayer is not aware that people who officially qualify as running a trading business receive special tax treatment. Their income comes from the profit they make by trading options, equities and other asset classes, and is viewed as “investment” income. Investment income is taxed differently than salary and wages, which are considered “earned” income. There are significant differences between the way that investment income and earned income are taxed and how the two can be combined. Let’s take a closer look at what being considered a trader entails, and what its impact could be. The Requirements for Being Considered a “Trader” The Internal Revenue Service defines a “trader” as a person in the business of buying and selling securities for their own account. The criteria for this classification include: Seeking profit from the daily movements of the market and from changes in securities prices rather than from interest, dividends or the appreciation of capital The level of activity of trading must be considered substantial The activity must be conducted regularly and continually There are also specific criteria for qualifying as a “trading business.” They are: Adhering to typical holding periods for buying and selling securities How often you trade during the year and what the dollar amount of those trades are How much the business’ trading is done for the purpose of livelihood income How much time is spent on trading Even if you consider yourself or call yourself a trader, a day trader, or a trading business, the IRS will analyze the levels for each and determine whether they are high enough for you to get the tax benefits that go with the title. Those whose volume does not reach the IRS’ qualifying levels will be considered an investor. What are the advantages of qualifying as a trader? Consider a scenario in which an individual earns a wage of $100,000 and an additional $30,000 by trading stocks. As an investor, the $30,000 will be taxed at either the short-term or long-term capital gains rate depending upon how long you held the position. Likewise, if you lost that same amount from your investments, you would be unable to reduce your earned income by that amount: you would be limited to no more than $3,000 in losses against earned income and still be taxed on $97,000 of taxable income. As a qualified trader, however, you are entitled to approach the taxes on gains and losses differently, using an accounting method called “mark-to-market” that determines values using prevailing market price. The $30,000 in losses on your trades would be subtracted from your $100,000 in wages, reducing your taxable income to $70,000. It seems pretty obvious, therefore, that anybody who can qualify as a trader should do so, but it is not that simple. You can’t look at your successes or failures as a trader and then decide at tax filing time what you want to do: It is a status that you need to elect in the previous year. Determining that you qualify for this status can lead to filing other advantages. For example, filing Form 6781, Gains and Losses from Section 1256 Contracts and Straddles, is specifically for those whose trades include products like foreign exchanges, index options, traded futures and other marked-to-market products. These provide you with a special 60/40 tax treatment under which as long as you’ve been holding your position for a specific period of time — even as short as three days — you’ll be able to have them taxed as though 60% are long-term capital gains and 40% are short-term capital gains. A $1,000 net gain on an index option would only see 40%, or $400, taxed at the higher short-term capital gain rate that is the same or ordinary income, while $600 (or 60%) would be taxed at the lower long-term capital gains rate.