Robinhood day trader looking at $800,000 tax bill even though he only made $45,000 trading stocks. Yes, this can really happen.

Mar 30th

It does not sound possible, but we're not talking math or logic here, we're talking the tax code, and with the tax code, "2 + 2" can sometimes equal "you're hosed."

How is this possible?

A little background first.

The case of the Robinhood trader, who hasn't been identified, was first highlighted in Morningstar by Alexandra Macqueen. She describes how Brian Wruk, a financial planner, received a text from the 30-year old investor who was facing an $800,000 tax bill. Like many, the investor, who works full-time in insurance, opened a new brokerage account in 2020 and quickly scaled his trading. He had between $200,000 and $2 million in trading volume per day, completing between 10 and 50 trades daily, according to Morningstar.

The guy worked in insurance making $60,000 a year and he traded $45 million worth of securities last year.

That's A LOT of volume, although the fact he managed to net $45,000 in gains is pretty impressive. He could just as easily have lost $45,000. Or more.

Unfortunately, there's this thing called a "wash sale rule."

"This poor soul traded all of the popular stocks you see in the media consistently all year long. . . [but] he never knew anything about the wash sale rules" wrote Wruk. "He booked a profit but was disallowed all the losses because he never once waited the 30 days on those stocks to book the loss," added Wruk.

What is the "wash sale rule?"

The wash-sale rule is an Internal Revenue Service (IRS) regulation that prevents a taxpayer from taking a tax deduction for a security sold in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys a "substantially identical" stock or security, or acquires a contract or option to do so.

In short, if you sell a stock at a loss and purchase that same stock (or something very much like it) back within 30 days you can't count that loss as a deduction against your gains that year.

The intent of the rule was to prevent investors from selling securities solely to generate a loss for tax purposes. If you sell a stock for $100 that you bought for $120, and then buy it right back for $100 the IRS considers that a "wash sale" in that nothing really changed as a result of the two transactions ("it's a wash"), you just wanted to create a $20 loss. They don't permit that unless you wait 30 days first.

Why 30 days? It's considered long enough that you have real risk that the stock will have a big run while you're waiting to repurchase it but not so long as to be punitive.

Sounds arbitrary? Welcome to the tax code.

You will not be surprised to learn that the IRS does not consider the reverse a wash sale, that is, if you sell a stock for a gain and then purchase it right back guess what? You still have to pay taxes on that gain in that year.

Have I said "welcome to the tax code" already? I feel like I've said that already.

You probably already see the kind of trouble a day trader could get himself into.

Trading in and out of stocks, 10 to 50 times a day, you are going to book all kinds of small gains and small losses, in this person's case, maybe a few hundred on average. As a wild guess, not knowing his exact circumstances, we're talking close to $2 million in both gains and losses with gains outpacing losses by the earlier mentioned $45,000.

The problem is, the IRS only counts the gains, not the losses. Depending on his circumstances, he should be able to use those losses to raise his cost basis potentially saving him some taxes in the future, but that doesn't help him right now.

This is a really good example of not knowing what you don't know. If you are a normal human being who thinks in logical ways, there really is no reason why a thing such as a wash sale would ever occur to you, which is why, no matter what, you should always do some research into any new venture with which you have little to no familiarity.


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