Do you trade stocks more often than most people change their socks? Then you need to understand how Uncle Sam views your habit. Otherwise, come April 15, you'll be suddenly confronted with a mountain of paperwork. And those profits? Well, they'll seem a lot smaller once the Internal Revenue Service has taken its share.

There are, however, some strategies that active investors can use to reduce their tax bills — and make life much more pleasant come tax season. Here's what you need to know about them.

Trader vs. Investor
In the world of taxes, "trader" and "investor" each has a special meaning that carries with it some pluses and minuses. Most individuals — even those who trade a few times a week — are, by the IRS's definition, investors. But if you spend your days buying and selling stocks like a hedge fund manager, then you are probably a trader, a title that can save you big bucks at tax time. How? By allowing you to fully deduct all your investing expenses, such as newsletter subscriptions, your home office and your computer equipment.

So what are you, you ask, a trader or an investor? This is one of the fuzziest areas of our fuzzy tax code. "The question is clear; the answer is not," says Don Roberts, an IRS spokesman. The only way to define your status is to go by the guidelines laid out in several court cases that have addressed the question.

The courts say you are a trader if:

• You spend lots of time trading. Preferably, you don't have a regular full-time job. (My reading is, you can also be a part-time trader, but you had better be buying and selling a handful of stocks just about every day.)
• You have established a regular and continuous pattern of making lots of trades (several almost every day the markets are open).
• Your goal is to profit from short-term market swings rather than from long-term gains or dividend income.

If you think you qualify and want to know the nitty-gritty of the rules, see More Tax Tips for Day Traders. If you're not so sure, here's how I think these court cases apply to the real world. Say you spend 10 hours a week trading and total about 200 sales a year, all within a few days of your purchase. In my book, you're an investor, not a trader. You are not spending enough time or trading often enough to satisfy the IRS. How about 20 hours a week and 1,000 short-term trades? I think that amount of time and trading gets you there. If you spend 30 hours a week, make 5,000 short-term trades a year and don't have a full-time job, even the IRS should agree without a fight. If you choose, you can actually be both a trader and an investor. You must segregate your long-term holdings by identifying them as such in your records on the day you buy in. Then they won't "taint" your trader status.

Trading Points
If you've passed these mushy hurdles and qualify as a trader, here's your reward. According to the tax law, traders are in the business of buying and selling securities. From the IRS's perspective, you are self-employed in this activity, meaning you can deduct all your investing expenses on Schedule C, like any other sole proprietor. This is great, because investors have to account for these expenses on Schedule A, where they can write off only the amount that exceeds 2% of their adjusted gross income. Plus Schedule C writeoffs reduce your adjusted gross income, which raises the odds that you can fully deduct all your personal exemptions and take advantage of other tax goodies.

You can also deduct your margin account interest on Schedule C and probably take an immediate writeoff of up to $105,000 for 2005 ($102,000 for 2004) for equipment used in your trading activities more than 50% of the time (computer stuff, desk, bookshelves, fax machine, etc.; it's called a Section 179 writeoff). Home-office deduction? Sure, as long as you use the space regularly and exclusively for trading and the deduction doesn't throw you into a net loss position. Finally, you don't have to pay self-employment tax on your net profit, because capital gains are exempted. All in all, a pretty good deal.

If you're a trader, you will still report gains and losses on Schedule D, and can still deduct only $3,000 in net capital losses each year. All this makes for a pretty funky-looking tax return. Schedule C will have nothing but expenses and no income, while your trading profits (we hope) will end up on Schedule D. I recommend attaching a statement to your tax return to explain the situation.

Mark-to-Market Traders
If you qualify as a trader, the IRS has a deal for you. Under normal circumstances, when you sell a stock at a loss, you get to write off that amount. But if you buy the same stock within 30 days, before or after you sell, the IRS considers it a "wash sale" — and you have a tax accounting nightmare to deal with. Fortunately, you can become what's called a "mark-to-market" trader, meaning that you will automatically become exempt from the wash-sale rule.

Here's how the mark-to-market rules work. On the last trading day of the year, you pretend to sell all your holdings. Even though you still really hold the stocks, you book all the imaginary gains and losses as of that day for tax purposes. You then begin the new year with no unrealized gains or losses, as if you had just bought back all the shares you had pretended to sell.

Being a mark-to-market trader has another advantage. Normally, investors can deduct only $3,000 in capital losses in a given year. But mark-to-market traders can deduct an unlimited amount of losses, which is a plus in a really awful market. As a mark-to-market trader you should report your gains and losses on Part II of IRS Form 4797. For more information, see IRS Revenue Procedure 99-17 in Internal Revenue Bulletin 99-7, which is available at the IRS Web site.

Drowning in Paper
How can you possibly account for hundreds of individual trades on your tax return? After all, the IRS wants not only to know your profit or loss from each sale, but a description of the security, purchase date, cost, sales proceeds and sale date. That's what many new traders are faced with around April 15 each year. Just scrawling in your total long- and short-term gains won't cut it with the IRS, either.

The best way I've found to handle this mess is to buy financial software and use the feature that allows you to download trading data from online brokers. Then you can transfer all the data into your tax preparation software without breaking a sweat.

If you insist on doing this by hand, then I recommend — at a minimum — showing the following on Schedule D: your net short- and long-term gains and losses, total sales proceeds and the total cost of your shares. That way, the IRS can still reconcile your return with the information that your broker provides. Attach a statement saying you will provide the details on request.

The Rest of Us
Truth be told, few people qualify as traders. If you're an investor in the IRS's eyes, you account for your gains and losses on Schedule D, just like always. And your expenses now fall into the undesirable category of "miscellaneous itemized deductions." You can't claim a home-office deduction, not for this anyway, and you can depreciate equipment over several years instead of all at once. On Schedule A, your investment expenses are combined with other miscellaneous items, such as fees for tax preparation, and you can write off only the amount that exceeds 2% of your adjusted gross income. And even if you do have enough itemized expenses to get a real deduction, you might get hit with the phase-out rule, which costs you three cents of every deductible dollar for every dollar of income above $145,950 ($142,700 for 2004).

One positive note: You can write off your margin account interest to offset the income you earn from your investments, such as interest, short-term capital gains and the like.