When DIY Investors go horribly wrong

By Larissa Fernand |  29-03-21 | 
 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

In the frenzied bull run of 2020, a friend who never dabbled in equity, began trading. Not as a professional trader employing technical analysis, but just buying and selling stocks. She proudly confessed that she has a “knack for trading”.

It is not these delusions of a bull market that I want to refer to, but the tax implication. She was clueless about the short-term capital gains (STCG) tax she is subject to.

Alexandra Macqueen documented a more dramatic incident in Morningstar.

On March 22, Arizona-based financial planner Brian Wruk of Transition Financial Advisors Group, Inc. got an “urgent text” from a newbie investor - who we’ll call Derek. Age 30 and working full-time as an insurance agent, he was faced with a tax bill of $800k, although he’d only earned $60k at his day job.

Derek opened a brokerage account early in 2020 with $30k in cash, which his brokerage allowed him to triple through margin for a total of $90k available for day trading. Then, throughout the year, he completed between 10 and 50 trades per day, with roughly $200k to $2 million in trading volume, three to four days per week.

As Wruk explains, “In 2020, Derek transacted $45M – yes, million – in total trades for a net profit of $45k at the end of the year – or so he thought. Instead, when he input his Form 1099-B (a U.S. federal tax form recording gains and losses during a tax year) into tax filing software, he had $1.4M in capital gain income and a tax bill of just over $800k.”

He earned $60k at his day job, a net profit of $45k from trading, and a tax bill of $800k.

Derek’s taxable capital gains result from the “wash sale” rule, an IRS regulation prohibiting an investor from claiming a loss by selling and purchasing the same or similar securities without a 30-day holding period. The wash-sale rule provides that if an investor wants to sell a security at a loss, then buy the same or a “substantially identical” security within 30 calendar days either before or after the sale, the wash-sale rule will kick in and no loss will be claimable for that security on the current-year tax return.

Derek’s lack of knowledge of the wash-sale rule is where he went astray: “This poor soul traded all of the popular stocks you see in the media consistently all year long,” says Wruk, “and per U.S. tax rules, Derek booked a profit – but was disallowed all the losses because he never once waited the 30 days on those stocks to book the loss.

Remember the absolutely tragic suicide of 20-year-old Alex Kearns? He misunderstood his account balances and thought he owed hundreds of thousands of dollars for stock market losses on Robinhood. The day after Alex took his own life, Robinhood sent an automated email suggesting the trade had been resolved and he didn't owe any money.

Please spend time understanding your trading strategy and the tax implications of your transactions. The above incidents show the unintended consequences of proceeding without professional advice.

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ninan joseph
Apr 3 2021 07:23 PM
 Yes the story of 20-year-old Alex was really, really sad. Not to exaggerate, but something similar I have faced with Icici Direct as well. I believe, icici Direct will allow the users to buy against a previous sell transaction although cash is not in the account. Sometimes sell proceed come later and on occasions, I used to get an email saying my account is in square off mode and if I do not fund the account, my shares could be sold. When the first time, I saw this, I panicked and started calling my RM, who advised me not to worry. It was a system generated email saying at that moment of time, the account is in square off mode and later when the credits came in, it was settled. If I wished I could fund the account and remove the square off position. But when I first read the email, and that they are going to sell my shares, it was bad.

But I can understand what poor Alex must have gone through. Sad, may his soul rest in peace.

First time, I am reading about "wash sale rule" - quite interesting. Is there any similar rule in India.

Hope Derek got his waiver from the tax authorities.
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