Taxes can consume 50% of your trading profits.

Because most traders do not know how to manage this huge expense we are providing this short column on how taxes can affect our trading accounts. It will appear every other week in this newsletter, and will try to address information which we feel will be both of interest to you, and that type of information which may save you money on your tax bill each year.

Since your taxes are the largest expense you have as an active trader, it is in your best interest to learn as much as you can about the tax code, so as to lower this cost.

All of us know that an important part of our trading success is to develop a trading plan, which reflects our personality as well as our propensity for risk. Each of us has probably spend a great deal of time in refining our trading techniques, changing brokers because of speed or cost, and overall evaluating each trade for why it is or is not successful. For a successful trader in many states 50% of all of the trading gains they make can be wiped out for taxes. If they are trading full time the trader then has their trading and personal expenses to pay, which depending on his/her style of living can take the remaining 50%. If through knowledge of the tax code we could save 25% of our tax expense we should be able to see how we can grow our trading account. This is what this column will be devoted to, giving you the knowledge so that you can make decisions which will reflect the tax saving methods you would like to implement.

TradersAccounting.com writes this column. If you have questions about anything written you may email them at questions@TradersAccounting.com

We hear that congressional negotiators are expected to include a new tax definition for certain trades. The package of provisions will be contained in the budget agreement. The new title will be "over the counter derivatives". The proposal, the Commodity Futures Modernization Act of 2000, will generally create a new exchange-trading instrument called a "securities futures contract" and treat it in the same manner as transactions in stock and stock options.

According to a Joint Committee on Taxation description of the same bill the house passed in October on a 377-4 vote, a securities futures contract is defined as a contract of sale for future delivery of a single security or a narrow-based security index. It would not be treated as a commodities futures contract for purposes of the Internal Revenue Code.

According to the JCT, until the Treasury secretary issues regulations, securities futures contract would not be treated as section 1256 contracts and thus would not be subject to the mark to market rules of section 1256 and would not be eligible for 60% LONG-TERM CAPITAL GAINS TREATMENT. Instead, gain or loss on the contracts would be recognized under the general rules relating to disposition of property.

Those regulations will b e required by July 1, 2001, and should treat dealers in securities futures contracts the same as options dealers.

The draft Form 4797 for tax year 2000 includes updated line instructions for line 1. In the past, the IRS only wanted taxpayers to include the proceeds from their 1099S. Now in addition to this, the IRS wants taxpayers to include the proceeds reported on Form 1099-B, proceeds from Broker and Barter Exchange Transactions, when the taxpayer has made the mark to market election.

According to the IRS spokesperson, for each stock or commodity marked-to-market, a separate transaction should be indicated. Entries for individual transactions should include the actual purchase date and a sale date of 12/31 of the year in which the FMV is recorded. If the number of transactions exceeds the space provided on the form, a separate statement should be attached listing each individual sale and separately listing each asset market to market.

All mark to market transactions are to be reported on line 10 of form 4797, regardless of the holding period.

In a "short sale", an individual contracts to sell stock (or other securities) that is not owned. The seller generally usually borrows the stock (or security) for delivery to the buyer. There generally is a premium which the seller has to pay for the privilege of borrowing such stock and will usually be required to reimburse the lender for any dividends paid during the loan period.) At a later date, the short seller will repay the borrowed stock to the lender with shares he/she held (but were not available) at the time of the short sale, or with shares he/she purchases in the market, whichever he chooses.

The act of delivering the stock to the lender in repayment for the borrowed shares closes the short sale. The date the sales agreement is made is considered the date of the short sale. The purchase of a put is treated as a short sale if you hold substantially identical securities short term at the time you buy the put.

How are Short Sales Taxed?

If the short sale results in a loss when terminated, the taxable event following the short sale occurs when the seller delivers the stock to the lender to close the sale. This will be considered a capital loss, and whether it is, long or short term in nature will generally be determined by how long the seller held the stock he used to close the sale. Wash sales can be present in short sales.

The premium paid by the investor to borrow the stock is an expense incurred for the production of income. However, if you are trading in your name rather than as a business and you hold the sale open for a period exceeding 46 days this amount is generally treated as interest expense (subject to the limitation on the deduction of investment interest).

Constructive sales? What are constructive sales?

If the taxpayer holds an appreciated financial position, or a position that has appreciated during the period of the short sale, that is the same as or substantially identical to the property sold short, the short sale will be treated as a constructive sale of that position.

A constructive sale results in immediate recognition of gain as if the position were sold, assigned or otherwise terminated at the fair market value on the date of the constructive sale.

Ø An appreciated financial position is a position with respect to any stock (and other items) where there would be a gain if the position were sold, assigned, or terminated. A position is further defined as an interest, including a futures or forward contract, short sale or option.

Ø Section 1259 of the Code provides for special treatment for constructive sales of appreciated financial positions.

How do we treat Constructive Sales for tax purposes?

Generally, you report a short sale in the year in which you close the short sale by delivery of replacement stock. However, if you have a constructive sale (short sale against the box), you report the transaction in the year of the short sale, even though delivery of the replacement stock is made in a later year.

Example: In March of 2000 you buy 100 shares of XYZ for $10 a share. (100*10=$1,000.)

In December, you note the stock is going down and you sell short of 100 shares at $50. (100*$50=$5000) In February, you deliver the 100 shares to close the sale. The tax law treats the short sale as a constructive sale of an appreciated financial position. You report the gain of $4000 for 1999, the year of the short sale, not when you close the sale.

Next time we will talk about Tax Straddles. Have a happy holiday, good trading.

Jim Crimmins
TradersAccounting.com
questions@TradersAccounting.com