Stock Trading PitfallDuring the past year many people whose work hours and income were reduced may have been tempted to start trading stocks as a way to make money. With the market going up after the brief downturn at the beginning of the COVID-19 pandemic, making money in the stock market looked like easy pickin’s. How hard could it be to do some trades and make some money? Many people offer courses in “day trading,” and they tout how they turned $500 into $50,000 or more in just a few weeks.

These “experts” are willing to train you to use their techniques. They describe all the things to consider and the resources you need, besides money: what trading platforms to use; what brokers to use; stocks that are good for trading; what time of day is best for trading; popular trading strategies such as “swing or range” trading, spread trading, momentum trading, etc. They also typically discuss limiting your risk, telling you to trade only with money you can afford to lose. But, on the flip side of risk management, they also tell you how to use “margin” to leverage the money you have to as much as 4:1 to increase your profit (but which also significantly increases your risk!).

These day trading teachers may tell you that you must pay income tax on your profit. They may even tell you how the tax on the profit is calculated. However, many of them fail to mention one critical rule in the US tax code and regulations you must generally use in calculating your profit. That rule is the “Wash Sale Rule.”

Day trading income is comprised of capital gains and losses. A capital gain is the profit you make when you buy low and sell high — the aim of day trading. The opposite of a capital gain is a capital loss, which happens when you sell an asset for less than you paid for it. Investors can offset some of their capital gains with some of their capital losses to reduce their tax burden.

Under the wash-sale rule, you cannot deduct a loss if you have both a gain and a loss in the same security within a 61-day period. (That’s calendar days, not trading days, so weekends and holidays count.) However, you can add the disallowed loss to the basis of your security. The wash-sale rule was designed to keep long-term investors from playing cute with their taxes, but it has the effect of creating a ruinous tax situation for naïve day traders.

See the Rule in Action

Here’s an example to illustrate. On Tuesday, you bought 100 shares of DEFG at $34.60. DEFG announced terrible earnings, and the stock promptly dropped to $29.32, and you sold all 100 shares for a loss of $528. Later in the afternoon, you noticed that the stock had bottomed and looked like it may trend up, so you bought another 100 shares at $28.75 and resold them an hour later at $29.25, closing out your position for the day.

The second trade had a profit of $50. You had a net loss of $478 (the $528 loss plus the $50 profit). Here’s how this works out tax-wise: The IRS disallows the $528 loss and lets you show only a profit of $50. But it lets you add the $528 loss to the basis of your replacement shares, so instead of spending $2,875 (100 shares times $28.75), for tax purposes, you spent $3,403 ($2,875 plus $528), which means that the second trade caused you to lose the $478 that you added back.

On a net basis, you get to record your loss. The basis addition lets you work off your wash-sale losses eventually, assuming that you keep careful records and have more winning trades than losing ones in any one security.

The wash-sale rule applies to substantially similar securities. DEFG stock and DEFG options are considered to be substantially similar, so you can’t get around the rule by varying securities on the same underlying asset. DEFG shares and shares of its closest competitor, PQRS, would probably not be considered substantially similar, so you can trade within a given industry to help avoid wash-sale problems.

So, if you are going to do some “day trading,” be very aware of this rule and keep meticulous records. If you want to truly be classified as a “trader” instead of an investor, you must meet several criteria that are beyond the scope of this article. Just know that a trader may have other options available for managing the “wash sale” situation.

If you have questions about your trading activities and how to report properly, contact the Sodowsky Law Firm to schedule a confidential meeting with one of our attorneys.

— Elden Sodowsky