Editor's note: TSC is doing reader Mike Bauer's tax return to illustrate how tax laws apply to real people. On Wednesday, we introduced Bauer and his family and spotlighted his Form 1040. Thursday , we showed you how Bauer handled the conversion of his IRA into a Roth IRA and the refinancing of his mortgage. Today, we'll take a close look at how he reports his trading activities on Schedule D. Saturday, we'll answer your questions in Tax Forum.

Mike Bauer played the trading game in 1998 and walked away with a $5,000 gain. Now it's time to give Uncle Sam his cut.

Bauer's meticulous record-keeping will, perhaps, ease the sting of the tax bite. Every night when he comes home from work, Bauer updates the Excel file that holds his schedule of trades. When buying and selling securities, he records all the information he'll need for his tax return, including the date acquired and sold, the purchase price and the sale price. In addition, he enters closing prices, highs and lows and average volume for all his holdings every night.

Come tax time, he simply prints out this schedule, titles it "Statement 1" and attaches it to the back of his tax return. (He should be sure to put his name and Social Security number on the statement, adds Brent Lipschultz, a senior manager at KPMG's Washington, D.C., national tax practice.)

An excerpt from Mike's Statement 1 looks like this:

Then all Bauer has to do is transfer the total proceeds and cost basis numbers from Statement 1 onto Schedule D -- Capital Gains and Losses. Here's how he should do it: On line 1 of Schedule D he should write "See attached Statement 1" in column (a). The total short-term sales price, $252,063, goes in column (d) and total short-term cost basis, $254,207 goes to column (e). His $888 short-term loss is recorded in column (f). He should apply the same methodology to his long-term trades. The total sales price, cost basis and gain go to line 8.

To see the long-term section of Mike's Schedule D, click here.

Bauer works as a trucker for Consolidated Freightways and has been trading securities on the side for a couple of years. His 1998 return reports about 50 trades for the year. During 1998, he was long a few stocks, but mostly he sold shorts. Because he moved in and out of his trades fairly quickly, he had to keep the wash-sale rule in mind. He also traded one nonequity index option, which brought up a whole new set of reporting rules, as we'll see. While we didn't go through every single trade he made, we did run his Statement 1 by our experts, and they came up with some suggestions that might save Bauer a little money.

Before we go further, here's a heads-up for traders who aren't brave enough to prepare their own returns: No matter how much you trust your tax preparer, you still need to double-check the figures on your schedule of trades. Your tax preparer is not going to audit that schedule for you. He'll simply take your totals and put them in the appropriate places on Schedule D -- especially if you have hundreds of trades.

Now let's look at some of the tax-reporting issues Bauer encountered on his Schedule D.

Wash-Sale Rule

The wash-sale rule says that if you sell a security at a loss, you can't deduct the loss on your tax return if you acquired a "substantially identical" security 30 days before or after the sale. But if you take a loss on a security and buy it back within the 30-day holding period, you can add your loss to the cost basis of the repurchased security. (See a previous Tax Forum for more details.)

Here's how Bauer reported a series of transactions in which he used options to protect against loss in his long position in Pre-Paid Legal Services (PPD:AMEX - news).

On Dec. 19, 1997, Bauer wrote (sold) seven PPD February 30 calls. On Jan. 12, 1998, Bauer bought back two of his PPD February 30 calls, which generated a $111 loss. Bauer disallowed this loss on his return because of the wash-sale rule.

Bauer reported the wash sale as a two-line transaction, which is in accordance with the Schedule D instructions. The first line reports that he bought back the two PPD calls. On the second line, he wrote "wash sale" as the description and added the disallowed loss back as a positive number in the gain column.

In terms of form, Bauer's schedule is right on. But our experts say Bauer should take another look at the numbers. Sometimes traders are so scared by the wash sale, they disallow more losses than they should.

Quick Tip If you trade options, as Bauer did, check out the chart on page 52 of Publication 550 -- Investment Income and Expense. It'll help you figure out your basis and any gain or loss.

On Feb. 5, 1998 Bauer bought back the remaining five PPD February 30 calls. It appears he is completely out of the position at this point. (He sold his long position Jan. 12, 1998.) But the wash-sale rule comes into play only if the position is still open. So our experts questioned why he disallowed the $111 loss.

There are two points to keep in mind when reviewing wash sales, says Ted Tesser, a certified public accountant in Boca Raton, Fla., and author of The Trader's Tax Survival Guide.

First, Bauer needs to go back over his schedule and determine if he had any open positions at Dec. 31, 1998, or if he repurchased the substantially identical security within 30 days of the sale. If he didn't, then there is no wash sale, says Tesser.

Second, traders also should make sure securities are substantially identical to begin with, says Tesser. That's not an issue here, but it might be an issue in some of Bauer's other trades that we haven't detailed here. With options, it gets a little tricky. As long as options on the same security have different expiration dates, you are out of wash-sale territory. Trading options with different strike and expiration dates is even safer.

Section 1256 Contract

While examining Bauer's schedule of trades, our experts noticed that he bought an S&P 500 index option on Oct. 1, 1998, and sold it two weeks later for a loss of $90. An index option is a Section 1256 contract, a term that applies to any regulated futures contract, foreign currency contract or nonequity option (options on stock index futures or broad-based stock indexes, such as the S&P 500 index).

Any gain or loss on a Section 1256 contract is subject to the 60/40 rule. That means 60% of the gain or loss is long term and 40% is short term, regardless of the actual time it's held.

In addition, if the trade is still open at year-end, it must be marked to market, meaning the security is treated as though it was sold for its fair market value on the last business day of the tax year. Because Bauer sold his position before year-end, mark to market is not an issue here.

So this option must be reported on Form 6781 -- Gains and Losses From Section 1256 Contracts and Straddles, says Richards.

To see what his Form 6781 should look like, click here.

Bauer should pull this trade off his Statement 1 attachment, where 100% of the loss would be treated as short term, and put it directly on line 1 of Form 6781, where the 60/40 rule comes into play. This move will increase his taxes, bottom line, but he has no choice. That's what the rule requires. Applying the 60/40 rule to Bauer's $90 loss leaves him with a $54 long-term loss and a $36 short-term loss. Those numbers should be reported on Schedule D, lines 4 and 11, respectively.

Reporting Shorts

If you short a security, the sale date is going to come before the purchase date. It might look weird, but it's the correct way to record the transaction on Schedule D. Check out Bauer's Statement 1. He was short two PPD February '98 calls so he reported the date acquired as Jan. 12, 1998, and the date sold as Dec. 19, 1997.

With a short sale, the taxable event occurs only when the short is closed. If Bauer were holding an open short position at year-end, he would not owe tax on it. But he still would've gotten a Form 1099B from his broker reporting the short sale as a sale. When filing his tax return, he would need to prove to the IRS the shorts was still open by drawing up a reconciliation schedule detailing the open position and attaching it to his tax return. For more details, see a previous Tax Forum.

Quick Tip Here's a mutual funds heads up: Bauer sold shares in PBHG Select Equity. There are several ways to calculate the cost basis of the shares he sold: first-in-first-out, average cost or specific identification. Any of these methodologies can be used. They just need to be used consistently. You can't use first-in-first-out one time, and average cost another. Fortunately, Bauer says he has been very consistent in using the specific identification method when selling mutual fund shares. That is, he identifies specific shares he wants to sell. "I think it is easier that way," he says. "With the way I keep records, I also think it is the least confusing method."