NEW YORK (CNNfn) - It's a story tax practitioners have heard all too often this year.
"Ted," an Austin, Texas-resident who asked not to be named, made $66,000 day trading last year - on top of his combined household income of $145,000. He didn't make estimated tax payments on those gains during the year and didn't much worry about it, assuming he'd owe no more than the maximum 20 percent capital gains.
He was wrong.
Under current tax law, Ted's $66,000 windfall gets lumped together with his ordinary income, taxed at 31 percent and 36 percent on a graduated scale. Instead of owing $13,200 on those gains, as projected, his tax liability is actually $22,000.
That's because the more favorable capital gains tax rate only applies to investors with long-term holdings, or those who hold their assets for more than a year. Short-term holdings, including those bought and sold daily by day traders, are taxed as ordinary income at a rate of 15 percent to 39.6 percent.
 Ted's story gets worse. Since the beginning of 2000, he has lost the $66,000 he made last year in the market's violent mood swings. His tax bill remains the same.
"I've seen this a lot this year," said Beanna Whitlock, an enrolled agent and a licensed securities trader. "All those day traders out there who mistakenly thought they'd be paying 20 percent, their foundation is rocked when I tell them how much they owe. I've been in the business a long time and I have to say this has been the screwiest year I've ever seen."
Coming up short
Ted's story is among many being presented Tuesday by the National Association of Enrolled Agents to the House Ways and Means Committee, as part of its annual report card on the tax-filing season.
"We're on the front-lines, because we survey our members regularly, and we have found that day traders are one of the newest wrinkles we are seeing," said NAEA spokeswoman Sharon Cranford. "It appears to be a new phenomenon because of the bull market and our great economy. But there are tax consequences to day trading and I don't think all of them are aware of that."
The community at large, she notes, has witnessed a surge in the number of active day traders who failed to plan ahead, or make the estimated quarterly tax payments on their gains as required by law. That in turn opens them up to additional underpayment penalties.
(Click here for the IRS worksheet on its method for calculating an underpayment penalty.)
Many others, including Ted,"made a bet with the markets and lost -- leaving them short-handed when it comes to paying their share to Uncle Sam. Some dip into their kid's college fund or vacation savings to pay it off, and others merely set up an installment plan with the IRS. That saves them from paying the late filing fee, but they still owe late payment penalties, plus compounded interest fees on anything unpaid by the tax filing deadline, which falls on April 17 this year.
"There are a lot of people who made a lot of money last year and it's going to make a big impact on their taxes," said Richard V. Rueb, executive director of DayTraders USA, a membership trade group based in Newport Beach, Calif. "Come April 8 or so, I predict you're going to hear a big sucking sound coming from the market, as these day traders liquidate some of their positions to pay the bill."
Others, he said, including himself, will simply exit the market for a few weeks as a pre-emptive strike until the smoke settles.
The GOP crusade
Trent Duffy, a spokesman for the House Ways and Means Committee, said the tax rate for day traders is a hot issue on Capital Hill -- at least for the GOP.
"These day traders are getting crushed by short-term taxes," he said. "They are getting stuck paying the top rate at 28 or 30-something percent. Republicans have always fought for a capital gains tax reduction." 
He noted the committee chairman, Rep. Bill Archer (R-Texas), helped lead the successful campaign to lower the capital gains tax rate from 28 percent to 20 percent in 1998. But he notes tax relief initiatives have a long way to go before they benefit the day trader.
"We're still deciding if we should push for a capital gains cut this year," Duffy said. "The ironic thing is that we do all these estimates on what kind of impact a cut would have and then the U.S. Treasury says 'Oh, no. We can't afford it.' Well, we cut capital gains a few years ago and now we've got an enormous budget surplus. Much of it was generated by capital gains."
He also noted capital gains tax cuts has become less of a party-line issue.
"It used to be only the (big investors) got involved in the stock market," Duffy said. "But there are some Democrats now, too, who feel the capital gains rate (could be eased). It ain't a rich man's game anymore."
Still, others believe day traders should never benefit from the more favorable capital gains tax rate, since they are using the market as a profit making vehicle, rather than a tool for long-term financial planning, as traditional investors do.
No matter what happens in the future, however, it won't happen fast enough to help the day-trading community this year.
Gains vs. losses
If you're just dabbling in day trading, or you haven't fully explored the tax filing ramifications of it, there's a lot you need to learn.
For starters, you're required by law to make estimated tax payments on your earnings -- or face an underpayment penalty.
However, IRS spokesman Don Roberts notes the penalty is waived if you covered either 90 percent of your current year's tax liability through withholdings, or you covered 100 percent of your prior year's tax liability.
The person who owed $3,500 as an employee in 1998, for example, and quit their job to play the markets in early 1999 would have cleared the penalty hurdle by paying the IRS a similar $3,500 by the end of last year -- regardless of how much they brought home.
Heading into 2000, the estimated payment requirement could pose problems for last year's big winners, too.
"A very successful day trader who owed $50,000 on their 1999 taxes, for example, now needs to make estimated payments of $12,500 every quarter to cover himself for what he owed last year, and avoid the penalty," Whitlock said. "And what happens if he has a terrible year this year?"
Roberts noted, however, that day traders stuck in this scenario could still cover themselves if they paid in 90 percent of their current year's tax liability.
At the same time, day traders, or active investors who fill out Schedule D for capital gains and losses, may be surprised by the relatively low cap on allowable deductions. That's because you can only claim as a loss the total amount you earned, plus an additional $3,000.
Sound confusing? Here's an example. Say you claimed $10,000 in capital gains this year, but recorded losses worth $60,000. The rules state you can completely offset your $10,000 with your losses, plus an additional $3,000 -- for a grand total of $13,000.
The remaining $57,000 in losses gets carried over to offset any future gains, plus an additional $3,000 per year, Whitlock said.
In other words, if you report gains next year of $20,000, you could completely offset those gains with your losses, plus an additional $3,000 for a total of $23,000.
The only way around that is to file as a self-employed trader, as allowed in certain cases by the Taxpayer's Relief Act of 1997. As a trader, you will file a Schedule C form allowing you to itemize your profits and losses, as any business owner would. The $3,000 capital loss ceiling disappears for these individuals, but you also get stuck paying ordinary income taxes on your gains.
Ask your tax professional for guidance on whether it's best for you to file as a trader or investor going forward - - and which of the two you qualified as last year.
If you consider yourself a trader, rather than investor, you are instead viewed as a self-employed individual. In that case, you'd claim all your earnings and losses on Schedule C, for business purposes. It is this group of day traders whose profits are taxed at the higher ordinary income rates. But they aren't limited on the amount of losses they can deduct.
"It all comes down to whether you're defined as a trader or an investor," said Cindy Hockenberry, an enrolled agent with the National Association of Tax Practitioners. "There's so much misinformation out there on the distinction, because the IRS hasn't really issued definitive guidelines on it."
Lastly, she noted, anyone in the day-trading business should be aware that if they earn more than $126,600 as a single taxpayer, they begin to enter the phase-out zone for itemized deductions. That limit climbs to $128,950 for single tax filers in 2000, Roberts said.
"Once you hit that income level, you can't take as much of a write-off on your mortgage interest, your taxes or your charitable contributions," Whitlock said, noting you can even start to lose your deductions for dependents. "It used to be that if your adjusted gross income was more than $126,000, we'd tell you to buy a bigger house for the write-off, but not anymore."
In states where you're required to pay both federal and state taxes, tax professionals advise day traders to set aside roughly 50 percent of their income for the tax man. And don't forget, you'll need to tell the IRS what you bought, what you sold, when you did it, and how much you did it for on every trade you make.
That means you'll have to stay organized and keep records throughout the year, since your annual broker's statement will only include the specifics on securities you sold.
"The smart thing to do is to stay very, very closely connected with a tax professional," Whitlock advised. "There's a lot of money to be made out there, but there's a lot to be lost as well. Talk to someone who is knowledgeable so you understand the tax ramification of what you are doing -- and never lose sight of the fact that these are real dollars you are dealing with." 
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