- - Thursday, February 10, 2011


One of the questions that I continue to get is, what is the difference between an investor and a trader?

Notwithstanding that in the investment industry, there are particular jobs for traders and for investment management (analysts and portfolio managers, for the most part), the difference for some boils down to a question of investing style. We’ve all heard of the “buy and hold” strategy that characterizes the “patient investor”, and there have been more than few people who have called that methodology all but dead. Those naysayers tend to be more active investors — people who actively buy and sell securities in their account — but does that make them a trader?

The central issue to me in being an investor or trader hinges on the length of your investment horizon. On a more practical matter, the tax treatment is different, depending on if you’re an investor or a trader.

While many have their own interpretation of investors and traders, when it comes to taxes, it’s the Internal Revenue Service’s perspective that matters. For the IRS, investors “typically buy and sell securities and expect income from dividends, interest or capital appreciation.”

By comparison, the IRS defines a “trader” as some who 1) seeks to profit from daily market movements in the prices of securities, not from dividends, interest or capital appreciation; 2) the activity level must be substantial; and 3) you must carry on the activity with continuity and regularity.

In rereading the trader definition, “activity level must be substantial” seems somewhat nebulous to me at first glance. Reading further, however, the IRS goes on to spell out that “If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader.” Hmmmmmm.

Should your trading activities qualify as a business, the “fun” is only beginning, because of the detailed record keeping and additional IRS-related paperwork that is required. A trader in the eyes of the IRS has to keep detailed records of investment positions, especially if he or she is blending investments (longer-term perspective) and trades (shorter term). As one would expect, that impacts your tax position.

While I do not claim to be anything close to resembling a tax person, let alone an expert, the gist is the following — when an investor sells a security, it results in capital gains and losses that must be reported on Form 1040, Schedule D, Capital Gains and Losses. Investors can deduct some expenses of producing taxable investment income, such as expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. Investors, as defined by the IRS, cannot deduct commissions and other costs of buying and selling securities, and investors are not subject to self-employment tax.

Again, I’m not a tax expert, and I would urge you to review this in greater detail in Publication 550, Investment Income and Expenses, on the IRS website(www.irs.gov).

For those who have a trading business per the IRS, the tax treatment hinges on whether the trader made an election under Section 475(f) to use the mark-to-market method of accounting. If that election was not made, then trading-related gains and losses are treated as capital gains and losses that must be reported on Form 1040, Schedule D.

However, if the mark-to-market election was made, then the gains and losses from sales of trading-related securities are treated as ordinary gains and losses and reported on Part II of Form 4797, Sales of Business Property. As I mentioned above, a trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The reason is that those securities held for investment are not treated as ordinary gains and losses, but rather capital gains and losses.

That all-important mark-to-market election must be made by the due date of the tax return for the year prior to the year for which the election becomes effective. In other words, when filing your 2010 taxes, you would need to make the election then for the 2011 tax year. More on how to make that election can be found in the Mark-To-Market Election for Traders section found on Schedule D Capital Gains and Losses on the IRS website.

With 2010 tax returns due in several weeks, check the guideline if you need to, decide if you’re an investor or a trader, and get your paperwork in order.

Chris Versace, the Thematic Investor, is director of research at Think 20/20, an independent equity-research and corporate-access firm in the Washington, D.C., area. He can be reached at [email protected] At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.



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