Capital Gains and the Active Trader

Capital Gains and the Active Trader Generating capital gains is what trading is all about, for isn't the goal of any trader to generate lots and lots of gains? Yet the sheer volume of trades generated by most active traders is cause for concern.

The Dilemma:
Have you ever wondered, "How am I ever going to match up all of my trade transactions for the year so that I can..."

• Prepare a properly matched list of my gains and losses?
• Calculate and adjust for any wash sales?
• File my taxes on time?

Your Brokerage 1099:
Your typical online brokerage is not much help in this regard. The IRS requires that a brokerage firm provide its clients with a very basic Form 1099, which generally only reports your total gross proceeds from the sale of stocks.

Some brokers provide a list of sale transactions, some just provide the total. Some provide a list of your purchases, some do not. Some report option sales, some do not. And we have yet to see a broker 1099 that accounts for any open positions going into the year, or unsettled trades both going into the year and at year end!

Your Brokerage Trade History Report:
In addition to providing a Form 1099 at the end of each tax year, most online brokers provide some type of trade history report. This can be in the form of a daily, monthly, or yearly statement which includes a list of trades executed during that period. Reports may also be available that list trades executed during a specific range of dates.

However, you will inevitably find that there are absolutely no clear, consistent standards for broker trade history reporting...even within the same brokerage firm. One broker report will identify an equity or option traded in your account by ticker symbol, while another will give a long description. This lack of consistency in reporting can make proper trade matching a challenge.

Order of Execution:
Some online brokers indicate the time of day a trade was executed and list trades in the exact order of execution, but many do not. A few get the order of execution all out of whack only on certain days of the year!

This creates a giant headache for the active trader. Since the IRS requires strict First-In First-Out (FIFO) trade matching, if trades are listed out of order, they must be put into proper order of execution before proper trade matching can be accomplished. A trader is thus forced to manually match trades because there is no automated way to do so.

Short Sales:
Some brokers report whether a trade is short or long, while many others simply report "buys" or "sells." If your trade transactions are listed in the proper order of execution, then it is possible to determine whether the trade is long or short by examining whether there are any open shares at that particular time for that security.

If there are no open shares, and you are matching a sale, then the sale can be assumed to be short. The same holds true for a buy transaction. If at that point in time you have nothing open, long or short, then the buy can be assumed to be a long trade. As you might assume, doing this by hand is not easy.

Commissions:
Some brokerages report the commissions in a separate column, while others include them in the total amount, while still others do not report the commissions paid for each transaction at all. This latter condition makes it virtually impossible to accurately report your gains and losses!

How can anyone possibly make sense of such inadequate reporting? I don't have to tell you that doing all this manually is quite complicated and very time consuming. Many accountants have been known to charge hundreds or even thousands of dollars to properly match one's trades (with some charging as much as $0.25 per matched trade).

Investors versus Traders:
In the old "buy and hold" days when an investor generally made only a handful of trades throughout the year, trade matching did not present much of a problem. However, today there are many active traders who make hundreds, if not thousands or tens of thousands of trades per year. Without an automated method, an active trader is forced to spend countless hours manually matching their trades.

How much is your time worth?

Wash Sales:
What about the dreaded IRS Wash Sale Rule? This rule as it applies to an active trader is an absolute nightmare! Most traders trade the same stocks, or options on the same stocks, over and over again. It is inevitable that they will generate wash sales, lots of them! Adjusting the cost basis of the trade that caused the wash sale and calculating the net affect of each of these at year end is beyond what most mortals can accomplish. For a discussion of this rule, please see Wash Sales and the Active Trader.

As IRS requirements such as the capital gain tax and the wash sale rule can have a significant negative impact on overall returns, it is vital for every investor or trader to have a good understanding of how these relate to their trading. The following pages will provide you with capital gains tax information on stock, options, futures and mutual fund trading, as well as a comprehensive yet concise discussion of the wash sale rule.

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