Disclaimer: The following information is meant for educational purposes and is not to be taken as professional tax advice. Please consult a tax professional to gain more accurate and comprehensive advice on the information provided below.
Tax Season Is No Fun For Anyone, Especially Active Traders
Tax time isn’t anyone’s favorite season. We look forward to it with the same eagerness we reserve for dental appointments. Tax time can be particularly intense for active traders. If you’re an active trader yourself, you know how complicated it can be to tally up your trades, especially if you’re a day trader or swing trader who happens to have a “favorite” set of stocks or ETFs to trade on a regular basis. The tediousness of tallying your trades for tax purposes can sometimes outweigh the potential benefits of trading on a more active level.
Tax Rules for Futures Trading Might Present Some Relief
Perhaps this is why many equities traders decide to give futures a try. In addition to the leverage that futures trading offers, the “tax” part of it may be simpler and perhaps even more favorable as compared with securities trading.
What it comes down to are two things: a capital gains advantage and an exemption from wash sale rules. There’s a third advantage as well, but it’s one that also applies to securities trading: capital loss advantages, aka “loss harvesting.”
Let’s start with the first, Uncle Sam’s treatment of capital gains.
1 – Futures Might Present Some Capital Gains Tax Advantages
Whether you trade stocks, ETFs, or futures, if you close out an active position to “realize” a gain, you have to pay capital gains taxes.
There are two kinds of capital gains taxes: short-term capital gains, for positions held less than a year, and long-term capital gains, for positions held over a year. Short-term capital gains are taxed at your ordinary income tax rate while the long-term capital gains tax rate is 15%.
When trading securities, which includes stocks and ETFs, you are subject to either short or long term gains depending on how long you held your position before closing your position.
But for futures, capital gains taxation follows the 60/40 rule: 60% of your gains are taxed at the long-term rate of 15% while 40% of your gains are taxed at your ordinary income tax rate.
Let’s illustrate this with an example. Suppose you make $1,000 in short-term profits trading stocks, and that your income tax rate is 22%. Your net profit after taxes is $780. Now, let’s shift a bit and say you made that same $1,000 trading futures. After the 60/40 split, your net gain after taxes would be $822. See the difference?
2 – Wash Rules Don’t Apply to Futures Trading
If you day trade or swing trade stocks, you might already be familiar with the IRS wash sale rule by virtue of it being a serious annual headache. A wash sale is one in which you sell shares (of a stock or ETF) at a loss, but then you either buy it back or you buy a “comparable” share within 30 days after you had originally sold it. This means that you can’t claim a capital loss for your sale, since you bought the shares back (within 30 days) at a lower price.
Here’s what it looks like in action:
- Stock XYZ drops and you sell all your shares at a loss of $500.
- You buy back shares of XYZ an hour later at a price much lower than your original purchase price.
- You close your position again, selling all shares again, but this time for a profit of only $100.
- Your net loss is $400.
Here’s where it gets complicated. You can’t claim a capital loss of $400 since you re-purchased the shares within the wash sale window. However, you can add your loss to the price you paid for your shares which, eventually nets you a capital loss.
But consider the hassle of having to do that for every set of trades and for every stock or ETF you buy and sell. What if you made wash-sales on the same security several times a day and several days a year? As a day trader, having to track and recount all of these trades can be a nightmare.
With futures, there is no wash sale rule. In the end, you get a statement combining all of your futures trades that amount to either a capital gain or a capital loss. Simple.
3 – Deducting Capital Losses
If taking a loss in futures trading has any benefits at all, it’s that you can deduct up to $3,000 in capital losses from your annual income (this applies to securities as well). Keep in mind, however, that the 60/40 rule applies to capital losses as well as capital gains. If you finish the year with a net profit in trading, you can also use your losses to offset your capital gains taxes—aka, “tax loss harvesting.” Another benefit is that you can also carry back losses for up to 3 years to offset your realized gains in previous tax years, or you can carry your capital losses forward if it exceeds $3,000 in the current tax year.
The Takeaway
Trading is hard enough without having to deal with the drudgery of tracking your trades for tax purposes. Although trading futures does entail greater risks than most securities, given the high leverage that comes with the territory, it also does present some tax benefits that may be helpful to those who trade regularly and frequently.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.