You don't need to be an around-the-clock trader to deduct the cost of investing. Even if you have a full-time job (either at home or away from home), you could be taking deductions related to your investment activity.
What are investment expenses? Outlays for things like fees for professional investment advice, accounting and legal fees related to investment activities, subscriptions to relevant investment publications, the portion of ISP charges incurred to follow and trade investments, the trusty home computer and even your home office. If you qualify for this last one, though, watch out — it can cost you more than it can save you if you're not careful. (See below.)
There are a few things you can't deduct. First, costs related to tax-exempt securities; they are nondeductible because they generate tax-free income. Second, trading commissions. These are added to the cost basis of the investment, giving you a tax break when you sell the securities. And finally, travel costs to attend investment conventions and seminars and stockholder meetings are generally nondeductible, as are attendance fees for conventions and seminars. (Investment interest expense, such as margin interest on brokerage accounts, is a whole different subject; use IRS Form 4952 to calculate what your deductible interest expense is.)
Who can take these deductions? Just about anybody, as long as these expenses — along with your other "miscellaneous itemized deductions" like tax-preparation fees and unreimbursed business expenses — exceed 2% of your adjusted gross income (AGI). (Much more favorable rules apply to "traders." See below.) But frankly, most taxpayers fail to clear the "2% of AGI" hurdle.
If you are lucky enough to rack up 2% in miscellaneous deductions, you may suffer one more insult from the IRS: Your write-off becomes less valuable the more money you make. Here's why. Taxpayers lose three cents of every deduction dollar for each dollar of 2004 AGI in excess of $142,700, or $71,350 for married-filing-separate status. (For 2005, the AGI thresholds are $145,950 and $72,975, respectively.)
Lastly, miscellaneous itemized deductions that survive the preceding two limitations are completely disallowed for alternative minimum tax (AMT) purposes. So if you are in the AMT mode, you may get little or no actual tax benefit.
The bottom line for investment expenses: you must have either relatively low income or rather hefty expenditures (or both) and avoid the AMT to net any significant tax savings — unless you can claim "trader" status. But don't give up hope without running the numbers. To show you how the rules work, we outlined three situations below.
Part-Time Investor With Full-Time Job Outside the Home (Or No Job)
Obviously, this is the most common situation. You can deduct expenses directly related to investing activities, subject to the 2% of AGI and itemized deduction phaseout rules. (As mentioned, expenses to generate tax-free income are nondeductible.)
If you use a home computer and peripheral equipment to manage your investments, you can depreciate the investment-use portion of the cost using the straight-line method — 10% in the first year, 20% in years 2 through 5 and 10% in year 6. Like other investment expenses, the depreciation is "thrown in the pot" with your other miscellaneous itemized deductions and is then subject to the 2% of AGI and itemized deduction phaseout rules.
Purchased software used for investment management can generally be written off over three years (or earlier if it becomes worthless). However, programs that are useful for one year or less should be fully written off in the year purchased.
Using your home office for investment management activities won't cut your taxes; only business usage (as opposed to investment usage) counts for this purpose.
Part-Time Investor Who Is Self-Employed and Works in the Home
Here you have to be careful. One wrong move and you lose your home office deduction. Another wrong move, and you'll be stuck paying more tax when you sell your house. Here's the scoop.
Your home office expenses (including depreciation, if you own) qualify as fully deductible business expenses if the office is used regularly and exclusively for business and meets one or more of the following criteria:
· it's your principal place of business or
· it's used regularly to meet with clients or customers in the ordinary course of business, or
· it's a separate structure apart from the residence portion of the home.
Warning: Don't use your home office for investment management activities. If you do, you will violate the "exclusively for business" rule. Technically, the IRS can throw out your entire home office deduction if you admit you so much as logged onto the Internet via your computer if the computer was sitting in your home office at the time. So, watch what you do. Use the computer in your bedroom when you are working on your personal investments.
But when you sell your house, your deductible home office could come back to haunt you. Here's why. If you sell your home for a profit, you will owe tax on the gain equal to your depreciation deductions from periods after May 6, 1997, despite the $500,000 tax-free gain rule for home sales ($250,000 for singles). This is not such a big deal in most cases, since you depreciate a home over 39 years, and the portion used for a home office is usually small. Plus you already saved taxes from claiming the depreciation write-off.
A bigger problem, however, is the possibility that you may owe capital gains tax on the home office portion of your home sale gain (not just the depreciation). This happens if you use the space for business more than three years out of the five-year period preceding the sale and it is not in the same dwelling unit as your residence (for example, a detached building). This tax will almost always exceed the meager break that you get from home office depreciation. So if you are contemplating a move in the next few years, don't take the home office deduction if your office is in a separate dwelling unit.
To the extent that you use your home computer for personal investment, it can be depreciated. (Say you use it 35% of the time for investments, you can depreciate 35% of its cost.) The same with the business portion, though if business usage exceeds 50%, you can deduct the appropriate percentage of the cost immediately under Code Section 179. (Keep a log to prove your case in the event of an IRS audit.)
Active Investor With No Other Job
If you meet the trader definition, you can deduct all your investment expenses on Schedule C. You can also deduct all of your home office expenses, provided you meet one of the three tests listed above (heed the same warnings), and you can claim Section 179 instant write-offs for computers and other equipment used more than 50% in your business as a trader.
What does it take to be a trader you ask? You must do more than just spend lots of time investing, according to several court cases dealing with the question. The quick and dirty summary: the courts want to see — in addition to lots of hours — lots and lots of trading activity (preferably daily), and they don't want to see a bunch of long-term investments. Even if you make daily transactions, you could be shot down if you typically hold what you buy for more than a few weeks. Traders are supposed to be mainly interested in short-term market swings rather than long-term capital growth opportunities or interest and dividend income. It also helps to invest broadly, rather than focusing on just a few industries or companies. In reality, most traders probably already know who they are — you're the sleep-deprived ones with cans of Coca-Cola lined up on your desk and a stack of brokerage transaction reports as high as your computer monitor. But for the complete story on how to decide if you are a trader, see our stories "Taxes on Day Trading" and "More Tax Tips for Day Traders."