How to ensure "capital" tax (instead of income) treatment for investment gains?

Question

I have a full-time job unrelated to the securities industry and I use a discount broker to manage my investments and would like to benefit from lower capital gains tax rates for my investment profits.

My goal is to hold about 50-70 securities (ETFs, equities) in my portfolio at any given time and I anticipate holding each security for at least 6 months before disposing/selling it. I'd like to add to my positions gradually via dollar-cost averaging and use covered calls to reduce the cost basis. My intent would be to execute about 10-20 buy transactions per month (often I'd be adding to existing positions) and perhaps about 5 sell transactions per month. Would using such a strategy put me at any risk for being flagged an active trader and subject to having gains taxed as income instead of the more favorable capital gains (w/ 50% inclusion) rate?

Furthermore, does the use of 15-20% margin significantly affect one's susceptibility to being flagged as an active trader?

Answer 1

My understanding is that you will be considered an investor at those levels. I hold more than that number of securities and have not been considered a trader. 5 sales per month sounds like nothing out of the ordinary.

In any case, consult this Interpretation Bulletin document:
http://www.cra-arc.gc.ca/E/pub/tp/it479r/it479r-e.txt

Some relevant texts:
"11. Some of the factors to be considered in ascertaining whether the taxpayer's course of conduct indicates the carrying on of a business are as follows:
(a) frequency of transactions - a history of extensive buying and selling of securities or of a quick turnover of properties,
(b) period of ownership - securities are usually owned only for a short period of time,
(c) knowledge of securities markets - the taxpayer has some knowledge of or experience in the securities markets,
(d) security transactions form a part of a taxpayer's ordinary business,
(e) time spent - a substantial part of the taxpayer's time is spent studying the securities markets and investigating potential purchases,
(f) financing - security purchases are financed primarily on margin or by some other form of debt,
(g) advertising - the taxpayer has advertised or otherwise made it known that he is willing to purchase securities, and
(h) in the case of shares, their nature - normally speculative in nature or of a non-dividend type.

12. Although none of the individual factors in 11 above may be sufficient to characterize the activities of a taxpayer as a business, the combination of a number of those factors may well be sufficient for that purpose."

Do note that in theory one can be considered a business even if your job is in an unrelated field. It depends on the "nature of trade":
http://www.cra-arc.gc.ca/E/pub/tp/it459/it459-80e.txt

As you can see there is some room for interpretation but I think you will be fine as long as you don't start daytrading.

P.S. to other posters: this is a Canadian tax issue, not a US one.

Answer 2

This may sound like chicken and egg time, but if there was no investment there would be no work. You can’t build a car or a machine in an open field when it’s raining – or even when it’s not. We have a graduated income tax, and rates go up along with income. Personal incomes are, in the aggregate, much higher than income from capital gains, so the government goes where the money is. As we saw after the Bush tax cuts of 2003, when capital gains taxes were reduced, revenues from capital gains taxes went up substantially. Investing is inherently risky, and investors try to balance risk with return. If the risk is high but the return is low, they won’t invest. If the risk is high but the return is also high, at least some investors will put their money on the table. I’m sure you would have no problem flipping a coin with me for a dollar. The odds are 50/50. But you wouldn’t do that with your house because if you lose it would be a disaster. Investors look at things the same way. The ultimate purpose of taxes is to raise money for the Treasury. When the government decides to inject an element of social engineering into the tax code, disaster is sure to follow. I may invest in a tech stock if the capital gains tax rate is 15 percent, but I will stay far away if the CG tax rate is 50 percent. You would do the same thing.

Answer 3

To be flagged as an active trader the IRS states:
1.must seek to profit from daily market movements
2.trading activity must be substantial
3.a trader must carry on the activity with continuity & regularity--

--also to be classified as a business, certain facts & ------------------circumstances are considered;

1. typical holding periods for securities bought and sold
2. frequency and $$ amount of yearly trades
3. extent pursued to produce income for a livelihood
4. amount of time devoted to the activity

If the total of all Section 1231 gains from sales of business property exceeds the total of all losses, all the transactions are considered to generate capital gain or loss. If the total of all gains do not exceed the total of all losses, all transactions are considered to generate ordinary income & loss.

With the new tax provisions there is capital gains treatment for self-created musical works beginning after May 17, 2006.
The (50% inclusion) is actually IRS Section 1202 stock gain allowing for an exclusion of up to 50% of the eligible gain on the sale or exchange of qualified small business stock held for more than 5 years.
Secion 1244 Stock losses (small business stock) can be deducted as an ordinary loss from the sale, trade or worthlessness of the stock. Losses from Sec. 1244 stock are not subject to the $3,000 annual loss limitation for capital losses and can be deducted as ordinary loss up to $50,000 each yera.

This is such a complex issue, buying and selling of stocks and securities, that you definately need to contact a qualified tax professional in your area. Especially now that the new tax provisions of Dec 9, 2006 have been signed. If you are in a 10%-15% Federal tax bracket, I would wait until 2008 to sell these securities and stocks because your capital gains rate will be 0% instead of the current 5%.

Look at the www.naea.org website for a qualified Enrolled Agent practicing in your area. Enrolled agents are licensed by the IRS and US Dept. of Treasury and must pass a rigorous exam, adhere to a strict code of ethics and have substantiated proof of continued education yearly( 90 hours every 3 years) thereby, hopefully having more knowledge of current tax issues.

With fewer than 40,000 EA's in the US...these are an ellite group of individuals. Surely there is a (Sch. D--Form 4797) qualified EA near you. Good luck!

Answer 4

I'm not sure if I understand your question, but if you're asking about capital gains rates, if you hold a security less than a year, you'll pay tax on short term capital gains instead of long term, so you'll pay at your normal rate rather than getting the capital gains treatment.

Answer 5

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Answer 6

25-30 transactions a month will not make you a "trader". Especially, if there are only 5 "sells". I will, however, make your tax return really fun......