This article on Tax Advantages of Trading Futures Vs. Stocks is the opinion of Optimus Futures.
Tax season is here, with the April 15 tax day just a few weeks away. If 2018 was your first year trading futures, then you’re probably a bit concerned about the tax implications, not knowing what to expect, worrying about the tax-related complexities that may befall you come Uncle Sam’s reckoning and payday.
Don’t be too worried. Yes, you will have to pay taxes on your capital gains if you ended 2018 with a net profit, but the process (at least compared with stocks) is a bit different, and in certain respects, possibly much less complicated.
After all, trading futures does have certain tax advantages, and that’s what we’ll cover in this article. There are a few benefits that just might work in your favor, so pay attention.
Before we continue, please note the following disclaimer: The information presented below should not be construed as tax advice. We recommend that you consult with a qualified tax specialist or tax accountant to ensure you receive the most accurate information on the current tax laws and to seek the most favorable tax treatment possible.
One Net Sum of Gain or Loss
Have you ever day traded stocks, as in lots of buys and sells, all accumulating toward an itemization mess piled up by the end of the year? If you have, then your first tax reporting experience might have been quite a shock. Chances are that you found yourself having to report every single trade you placed–itemizing each buy and sell–for every stock you’ve traded. And if you’ve placed hundreds of trades over the course of the year, you certainly know how complicated and overwhelming the tax reporting process can be.
Believe it or not, you might not have to deal with this when trading futures, whether you’ve traded one position or hundreds of positions over the course of the tax year. Fortunately, with futures, your brokerage sends you a 1099 B form. That’s right, one form, one figure: your net result from trading–gain or loss. You don’t have to report every single trade you’ve placed, possibly making the 1099 B a much preferable alternative, especially if you are an active trader.
Capital Gains May Favor the Futures Trader
You bought stock XYZ in January 2018 and sold it in December 2018 for a profit of $20,000. Coincidentally, you traded the E-mini S&P 500 and made an identical net profit of $20,000. Come tax time, you may owe Uncle Sam $4,400 for your capital gains tax on stock XYZ. For your E-mini S&P 500 trades, however, you own only $3,560.
Why is it, in the example above, that you are paying less in capital gains tax for futures versus stocks? Let’s back up and take note that capital gains taxation varies according to the kind of trade you place (long-term or short-term), the asset class you trade (stocks, futures, etc.), and your personal income tax rate.
Generally, stocks that are held for less than a year are subject to short-term capital gains, and the short-term capital gains rate is pegged to your personal income tax rate. Futures profits, on the other hand, are subject to the 60/40 rule, meaning that 60% of your profits are taxed according to long-term capital gains while 40% are taxed according to short-term capital gains.
In our hypothetical example above, we placed you at the 22% tax bracket (Married Filing Jointly with an annual income between $78,951 – $168,400; or Single with an annual income between $39,476 – $84,200).
- Stock XYZ: $20,000 x 22% = $4,400 short-term capital gains tax.
Your futures gains, however, are taxed differently according to the 60/40 rule:
- $12,000 x 15% (long-term cap gains) = $1,800
- $8,000 x 22% (short-term cap gains) = $1,760
Important: short-term and long-term capital gains can vary according to your personal tax rate, so be sure to consult a tax specialist or accountant!
To date, this 60/40 rule for futures stands fixed, potentially making capital gains taxes more favorable to the trader. Even better still, you don’t have to report each trade, just the net figure on your 1099 B form, making tax reporting much simpler.
Capital Losses
Similar to stocks and other investments, you can deduct up to $3,000 in capital losses from your annual income, as long as your losses outweigh your gains. Your capital losses will also be subject to the 60/40 rule. And if your losses happen to exceed your annual $3,000 limit, then you can carry over the remaining balance over to the following tax year. In fact, you can carry back losses for up to three years. If you are a position trader, the end of year marked to market rule also opens a few additional opportunities for gaining a potential tax advantage. We’ll cover this next.
No Wash Sale Rule
The wash sale rule can be something of a nightmare for active stock traders. Essentially, this rule prevents stock traders from claiming “artificial losses” when repurchasing the same (or a similar) stock within a 30-day period after it had been sold for a loss. In simple terms, you can’t claim a capital loss for a stock sale if you buy it back (or buy a similar stock) within 30 days of having sold it at a loss. Uncle Sam would consider this cheating, especially if you attempt to do some “tax harvesting.” But for active traders, you can imagine the kinds of difficulties this can present come tax time.
Because futures contracts are marked to market at the end of the year, futures traders are exempt from the wash sale rule. This may prove advantageous to day traders and scalpers who may buy and sell the same contract several times a day. Essentially, wash sales don’t apply. Interestingly, this exemption also comes with another rule that can be used to a trader’s advantage…
End of Year Marked to Market Advantages
As a Section 1256 contract, futures are marked to market at the end of each year. Traders can report all realized and unrealized gains and losses. For some traders, this may be an opportunity to tax-advantage futures by strategically timing the sale of a contract. Here’s how it works:
Let’s say you bought a contract worth $20,000 in March 2018. If by December 31, the last day of the tax year, the fair market value of your contract was worth $28,000, then you have an $8,000 gain subject to capital gains tax subject to the 60/40 rule. This will be reported in your 2018 tax return.
But let’s suppose you sold your contract in February of 2019 for $25,000. Then you can claim a $3,000 loss (also subject to the 60/40 rule) on your 2019 tax return. Why a $3,000 loss? Because the End of Year value of $28,000 is greater than the current contract value of $25,000 by $3,000. You can use this tactic to lower your tax bill, as you can also carry back losses for up to three years.
This is just one scenario among many, and you can imagine the different variations that may come into play when strategically planning your tax strategy. Be sure to consult a tax advisor or accountant who is knowledgeable about trading-related taxation. The more knowledgeable your advisor/accountant in regard to trader taxation, the more strategies he/she might have available, and the less of a headache it might be for you come tax day.
Trader Tax Status
Now, if you can qualify for trader tax status–and this is a big IF–then you can possibly receive even more tax benefits than the average trader. But qualifying for this status is not easy. For starters, you must be a full-time trader with no other full-time job. You can’t be a part-time trader who trades every day but receives your main source of income from another source of employment or (non-trading-related) business.
What does trader tax status give you? Mainly, you can claim your trading losses and business expenses as ordinary losses which can then be deducted from your annual income. You can claim losses beyond the $3,000 annual limit (basically, the limit doesn’t apply to you). And if you made large profits one year (for which you paid capital gains taxes) but lost a lot of money the following year, you can amend the previous year’s tax return to get a refund from the previous year’s returns wherein you had to pay taxes. Tax trader status may come with big advantages but trading as a “full-time” business also comes with great risk.
So, there you have it–a few key tax advantages to trading futures. Again, what we had just presented shouldn’t be taken as tax advice. Tax rules can get very complicated, and the various aspects and nuances of tax rules tend to change. So, to get the most accurate guidance and advice for your tax situation, we suggest that you contact a tax professional or accountant.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
