Tip No. 14: Tax Breaks for Traders

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Recent disastrous experimentation with day trading just might offer big tax savings.

Did you try your hand as a day trader recently? Hope you have some fingers left. While we can't help you out with your losses, we might be able to help you recoup some of your costs in other ways.

If you traded like a fiend in in the past, you just might qualify for some unexpectedly generous tax breaks. The catch is that Uncle Sam must view you as a trader as opposed to an investor. But once you pass the test, you gain access to a wide range of deductions, like being able to deduct home-office expenses as well as all of your trading-related outlays (for publications, Internet charges, phone calls, caffeinated beverages, etc.). In a nutshell, you might owe the Internal Revenue Service much less than you thought.

As you might suspect, however, unless you really were a full-time day trader last year, being labeled a trader is highly unlikely. That said, the line between trader and active investor -- as defined by the IRS -- is somewhat vague. The only way to ascertain the difference is to review several court cases that dealt with the issue. To begin with, a trader is obviously someone who spends an enormous amount of time trading. Now, if you trade all day and don't have a regular full-time job doing something else, this would qualify. But even if you do have another job, as long as you trade a handful of stocks just about every day, this should do the trick too. You also should be focused on short-term profits. And you have to have done this for at least six months.

Don't make the cut? You still might be able to deduct your investing expenses by listing them under "miscellaneous itemized deductions" on Schedule A of your 1040. Unfortunately, you can take these deductions only if they (along with your other miscellaneous deductions) equal more than 2% of your adjusted gross income, or AGI. And even then, your deduction will be further limited if your AGI exceeds $128,950 (or $64,475 if married and filing separately). Our story "Writing Off Your Investment Costs" will give you all the details.

Finally, if you do qualify for trader status -- and if you are continuing to frenetically trade this year -- you may also want to make what's known as a "mark-to-market" election for the tax year. Why? Because this tax-friendly election allows you to deduct more than the usual $3,000 limit on net capital losses. And with the way things have gone so far this year, being able to deduct really big losses could be a really big tax-saver. Just be sure to do it quickly. You must take action by the April 15 deadline for filing your tax return.