• The IRS handles active traders differently than investors.stock market analysis screenshot image by .shock from Fotolia.com
  
  For individuals who actively trade the financial markets, the Internal Revenue Service (IRS) offers special treatment and taxation of the gains and losses acquired through this activity. Note that the IRS rules for trading are separate from day trading rules established by the Financial Industry Regulatory Authority (FINRA) that outline who is permitted to day trade and how brokers must deal with clients who day trade. The IRS is instead concerned with how day trading income is taxed.
  
  

Trading as a Business

• In the financial industry, "trading" and "investing" are two very different activities. Many individuals engage in both, but they are not the same thing. Investors generally seek long-term gains and reap the benefits that appreciation and stock dividends provide. However, such investors usually work other jobs in addition to holding a stock portfolio. Traders, on the other hand, can receive special tax treatment for their stock market activities only if the bulk of their income is acquired through trading. The IRS does not publish specific criteria on how it quantifies trading activity as an actual business. However, it does offer some general rules that serve as guidelines for any trader who applies for special treatment. If you meet these requirements, you may qualify for "trader status" with the IRS.
  
  

Daily Fluctuations

• Unlike investors, who usually acquire capital gains and losses from long-term stock positions, the IRS requires that traders specifically seek returns from daily fluctuations in the financial markets. If a trader's trading history does not demonstrate this intention, then she will not get special IRS tax treatment for her trading activity. All income tax returns for investors and traders must include specific records of all trading activity.
  
  

Substantial Activity

• While there is no objective measurement for this rule, the IRS does require that traders who seek special treatment have "substantial" trading activity. If you only trade part-time or during some parts of the year, you may not qualify under this IRS rule. Additionally, your tax return must indicate that most of your income is created through trading. If your return shows other sources of income, you may not qualify. The IRS makes these assessments on a case-by-case basis.
  
  

Wash Sale

• If you qualify for "trade status" under the IRS rules, you receive special treatment for your trading activity. Normally, investors are subjected to the "wash sale" rule. All investment losses carry the potential for a tax deduction. However, if you purchase a stock within 30 days of selling it, either before or after the sale, you cannot deduct any losses associated with the position. However, day traders often buy and sell the same instruments every day. Their losses are not disqualified due to the wash sale rule if they elect to file under "mark-to-market" status. This option is only available to traders who meet the "trader status" requirements of the IRS.
  
  

Application

• As a rule, trader status is only granted for the year following your application to the IRS. You cannot claim trader status on a new return if you did not apply for it in the previous year. To apply, simply attach a personal statement explaining why you think you qualify for the trader status. Your statement must specifically mention your election to trader status "under 475(f) of the Internal Revenue Code." You can find additional information regarding this application on Schedule D of the IRS 1040 form.