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IRS demands day traders record every transaction

If you're a day trader, you know all about risk. But here's one sure thing -- the IRS wants a mound of paperwork from you.

Most taxpayers aren't true day traders, but investors. To be a trader -- and to qualify for the special tax treatment that traders get -- you must profit primarily in swings in daily market movements, and personally engage in the purchases or sales.

Taxpayers who spend a lot of time trading, especially those who don't have full-time jobs, are more likely to qualify as "true" day traders in the eyes of the Internal Revenue Service. Basing trades on profits from short-term market changes as opposed to long-term gains and dividend income also increases the chance of being perceived as a trader by the IRS.

Mark-to-market
Once you attain trader status, the IRS has special rules for you, some favorable, some less so.

The favorable ones give traders a break on capital losses.

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Most taxpayers who sell a stock at a lower price than they paid for it incur a capital loss. The loss reduces part of the taxes they owe.

If someone buys and sells the same stocks a lot, though, there is a problem. Generally, anyone who purchases the same stock 30 days before or after selling it transforms the sale into a "wash" in the eyes of the IRS. This could make it impossible for someone who is constantly flipping over stocks to ever claim a loss.

The IRS gives a break to day traders, however. They become "mark-to-market" traders and are exempt from the wash-sale rule.

How does this work? On the last trading day of the year, a day trader pretends to sell all holdings. He records all sales and gains that result, even though he still owns the stocks. His new year begins without any capital gains or losses. The trader then pretends to "buy back" all of the stocks that he never sold.

There is another tax break for mark-to-market traders. Most stock investors can only claim up to $3,000 as a capital loss in a given year. If someone is a mark-to-market trader, though, there isn't a limit on capital losses. This doesn't eliminate all the pain from a bad year, but it should ease it a bit.

The paper chase
Now, the really fun part. A lot of trading is bound to mean one thing to the IRS -- a lot of paperwork.

It doesn't stop at the loss or gain from each trade. The IRS expects all the details from every transaction, including each security's description, purchase date, cost, sales proceeds, and sales date.

Traders have two ways they can approach this task -- do it by hand, or with a computer assist.

Taxpayers can report their trades by hand on Schedule D; mark-to-market day traders use Form 4797. Regardless of which filing route you use, you'll have to record every single trade, reporting net short- and long-term gains and losses, total sales proceeds and the total cost of shares. You also should attach a statement offering to provide details on request.

If this sounds like a nightmare, it could provide the push you need to use a computer program for your taxes. Several programs allow you to download trading data from various online brokers. You can then use the tax program to transfer all the data onto your return.

Not only is the computer route likely to take less time, but it could prevent some unwanted scrutiny from the IRS. Keep in mind that the IRS is going to be trying to reconcile a tax return completed by hand with any information reported by your broker. Overlooking a trade or incorrectly reporting a detail could mean having to spend a day answering questions from the IRS. And, of course, that could be the one day that you make a killing in the market.

-- Updated Sept. 3, 2003

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