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Tax Considerations for Algorithmic Traders

Overview

If you are an algorithmic trader, chances are that you have spent a fair amount of time thinking about taxes. There are several considerations when it comes to taxes, and having a well thought out strategy can help you optimize your returns while complying with the rules. While tax laws are exhaustive and need personalized attention based on individual circumstances, we help you get a quick overview of some of the key regulations below. 

Short-term vs long-term capital gains

For algorithmic traders, it is very important to consider capital gains taxes when making buy/ sell decisions.

When you sell a stock for more than its purchase price, the result is a capital gain. However, there are two types of capital gains: short-term and long-term. The tax that you will pay depends on how long you held the stock before selling it, thus classifying it either as a short-term or a long-term gain. If you have held a stock for up to 1 year, then it will classify as a short-term capital gain. On the other hand, if your holding period of the stock was more than 1 year, then it is classified as a long-term capital gain.

Short-term capital gains are effectively taxed the same way as ordinary income. That rate can go up to 37% in 2023, depending on your own tax brackets.

Long-term capital gains are taxed between 0-20%, depending on your income threshold. For the taxable year 2023, individuals with taxable income below $44,625 pay 0%. Individuals with taxable income between $44,626 and $492,300 pay 15%, and investors with income above $492,300 pay a 20% tax rate on capital gains.

People often have the misconception that all capital gains are taxed more favorably than ordinary income. However, that is not the case. If you have a short-term algorithmic strategy, then keep in mind that short-term capital gains are effectively considered the same as ordinary income. 

Here’s a quick summary of tax slabs for individuals (singles) and how they might affect you:

Income (single)

Short-term capital gains tax rate

Long-term capital gains tax rate

Difference

Upto $11,000

10%

0%

10%

$11,001 - $44,625

12%

0%

12%

$44,626 - $44,725

12%

15%

(3%)

$44,726 - $95,375

22%

15%

7%

$95,376 - $182,100

24%

15%

9%

$182,101 - $231,250

32%

15%

17%

$231,251 - $492,300

35%

15%

20%

$492,301 - $578,125

35%

20%

15%

$578,126 and above

37%

20%

17%

Realized vs unrealized gains

There are two types of gains that investors can make: realized, and unrealized.

Realized gains are those which, as the name implies, have been ‘realized’ or have actually materialized. For example, if you bought stock worth $100 and sold for $150 before the end of the tax year, then the gains of $50 would be considered as realized gains.

On the other hand, if your stock was worth $150 but you were still holding it at the end of the tax year, then the $50 gains are only “on paper” and are considered as unrealized gains. 

The taxation treatment of the two is different. In the USA, only realized gains are taxed. Unrealized gains are not taxed, and you only pay tax when you actually sell the shares and the profit materializes. 

Further, the rate of tax depends on the long-term vs short-term definition that we discussed above. Stocks held for more than a year are taxed at long-term capital gains tax rates (typically more favorable than short-term capital gains tax rates). 

These two factors (only realized gains being taxed, and long-term capital gains tax rates being more favorable) could create a potential incentive for investors to hold stock for longer periods of time. One should keep these factors in mind while creating an investment strategy.

Tax-loss harvesting

We’ve discussed profits so far, but what happens when you make a loss? Tax loss harvesting can be an important tool that helps you see a silver lining in those losses. Simply put, the tax break from your losses can help offset some of the tax liabilities from your investing profits.

Obviously, as an investor you are not looking to make losses. So why does tax loss harvesting matter? It matters because it can allow you to make more pragmatic decisions. You can leverage market volatility to sometimes sell stock even below cost, and then use that tax break to reduce your overall tax liability. 

For example, if you're going to have to recognize $100 in capital gains in an investment account, you might sell other investments that would similarly generate a recognized loss of $80. In doing this, you can cut your overall capital gains to only $20 — which can lower your tax burden.

However, it should be noted that tax-loss harvesting only works on taxable investments. Many retirement accounts, such as IRAs and 401(k) accounts, are tax-deferred and therefore do not allow you to offset taxable gains. Therefore, you cannot use the tax-loss harvesting strategy with these accounts.

Wash sales

The IRS instituted the wash sales rule to prevent misuse of the tax-loss harvesting rule. Earlier, one could technically sell stocks at a loss at year end, use those losses to reduce tax liability, and then repurchase those stocks once again in the new year. However, the wash sales rule tries to get around this loophole.

A wash sale is when a person sells an investment at a loss and buys or acquires "substantially identical stock or securities" within 30 days prior to or after the sale. The wash sale rule also applies to any substantially identical stocks or securities purchased by your spouse or a company you own.

For example, suppose you buy 10 shares of ABC Co for $100. You sell these shares for $75 and within 30 days from the sale you buy 10 shares of the same stock for $80. Because you bought substantially identical stock, you cannot deduct your loss of $25 on the sale. However, you add the disallowed loss of $25 to the cost of the new stock, $80, to obtain your basis in the new stock, which is $105.

What is Schedule K-1 and is it relevant to me?

The purpose of Schedule K-1 is to shift the income tax liability from an income-earning entity to those who have a beneficial interest in it. Simply put, for partnership businesses, it’s the partners who are liable to pay interest based on their share (not the partnership firm itself). Thus, each partner is responsible to file their own income tax return in a Schedule K-1. Schedule K-1 can be found here.

Trusts and estates use Form 1041 to file their tax returns. Sometimes, the trust pays the income tax on its earnings itself (instead of passing it through to the unitholders). However, some trusts and estates pass income through to the beneficiaries. 

If you are a unit-holder in an investment corporation or mutual fund, you might receive a K-1. This shows the income that you need to report on your own tax returns. Whenever a beneficiary receives a distribution of income, the trust or estate typically reports a deduction for the same amount on its 1041. This is a mechanism to prevent double-taxation for the firm and the individual.

 Tax-filing (outsourced vs DIY)

As you think about whether to hire a tax professional or do your taxes yourself, think about the following questions:

i) How complex is your situation? If the majority of your earnings are through salary and only a small portion is through algorithmic trading, then this is potentially a simpler situation than someone who has additional complexities such as joint incomes along with trading gains from various types of securities.

ii) How well do you understand taxes? If you have a working knowledge of taxes, this may help you do your own research and file taxes. On the other hand, if you feel like an absolute beginner to this field, then you’d probably be better off seeking help.

iii) How much time are you willing to give towards tax filing? Most tax filing websites charge ~$150 for a standard tax filing procedure. If you think your time is more valuable than this, you should consider outsourcing this process.

At the end of the day, tax filing is a highly personalized process and you should take time to think carefully about your situation before deciding on which route makes the most sense for you.

Considerations for optimizing tax efficiency

For investors, the most important metric is “post-tax” profits. This is why it becomes important to have a tax-efficient strategy. It behooves algorithmic traders to spend some time thinking about tax planning. 

The first step to thinking about tax efficiency is understanding which is the correct type of account for you. Taxable accounts (such as brokerage accounts) are ideal for investments that you intend to hold for more than one year. On the other hand, tax-advantaged accounts (such as IRA, 401 (k), Roth IRA) are ideal for more actively managed funds which you think have the potential for short-term gain. 

Another consideration to keep in mind is portfolio rebalancing. Rebalancing is the selling and buying of stocks that have either grown beyond or fallen below your original allocation. During this process, you may end up increasing your tax liability or alternatively help yourself with some loss harvesting. During this process, it might be helpful to focus on your tax-advantaged accounts so that you can take advantage of short-term price movements without incurring higher tax rates. 

Few other considerations include more personalized issues such as estate planning (do you have some of your income going to a trust?), other sources of income, and thinking through joint income with your partner if applicable to you.

Conclusion

Taxes are an important consideration for algorithmic investors. One should spend time thinking about an efficient strategy to maximize post-tax gains. When in doubt, it always helps to consult the experts.

For algorithmic traders, it is worth keeping in mind that tax liabilities could tend to be slightly higher because of the nature of short-term trading involved in algorithmic strategies. However, one should remember that algorithmic trading strategies have the potential to generate attractive overall returns because they rely on rules-based investing that finds alpha in several ways. Read more about algorithmic trading strategies here.

(Disclaimer: This article is not meant to serve as tax advice in any manner. The purpose of this article is only educational in nature and tax laws are subject to change periodically. Please consult your tax advisor for a detailed explanation of these laws.)

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