Taxation of Short Sales

A short sale occurs when a trader borrows stock from his broker and sells it, hoping to profit by buying it back at a lower price. Short sales are a means to profit from market downturns or to hedge a position. Although a short sale is somewhat the reverse of buying a stock with the hope of profiting from an increase in stock price, the tax rules that apply to short sales are significantly different than those that apply to a long position.

Tax law treats covered short sales differently from uncovered short sales. A covered short sale is one in which you own substantially identical securities, which includes not only the stock itself, but also any call or put options in which the stock is the underlying asset, or any other security that can be converted into the stock, such as convertible bonds, or any other property that would hedge your stock position, such as a futures or forward contract. You are also considered to hold a substantially similar position in the stock if your spouse or closely related relative, or even a closely held corporation in which you are a major stockholder, also owns substantially identical securities. An uncovered short sale is one that is not covered as defined above.

An uncovered short sale gain or loss is always short term, because the holding period is deemed to begin when the stock is purchased that is used to close out the short sale. Since the short seller can only profit by buying at a lower price, he will wait until the day that he decides to close out the transaction to buy the stock, for it makes no sense to buy the stock back any sooner than that, since if the short seller believes that the price will go lower, he will wait until he thinks the price has reached its lowest point, then buy back the shares and close the short sale.

Before the tax law changed to disallow it, covered short sales were commonly used to postpone gains on long stock positions so that the lower long-term capital gains rate would apply. Specifically, you could sell short against the box, selling short stock that you already owned, so that your gains were protected until your long position could be sold, so that it would qualify for the long-term capital gains rate. (The term shorting against the box comes from the fact that, years ago, stockholders used to keep their stock certificates in safe deposit boxes.)

Whether the gain or loss from a covered short sale is short-or long-term depends on how long the stock or substantially identical property was held that was used to close the short sale.

The gain or loss on an uncovered short sale is reported in the year that the position was closed out, even if settlement of the trade occurs in the following tax year.

Example 1: You sell short 100 shares of ABC stock for $10 a share on January 5. On March 6 of the following year, you buy 100 shares of ABC stock for $5 a share to deliver to your broker to replace the borrowed shares, thereby closing out your short position. Because you held the shares that were used to replace the borrowed shares for less than 1 day, your capital gain is short term.

If you already own the shorted stock and the shorted stock was sold at a higher price than what you paid for the original stock, then tax law treats the sale as a constructive sale, even though you did not technically close out your position. Gain is determined based on the short sale proceeds and a new holding period for the original stock begins on the date of the short sale. If the price received on the shorted stock is less than the tax basis of the your long position, then a gain or loss is reported when the short position is closed out. If the shares of stock become worthless before the sale is closed, then the gain is recognized when the shares become worthless.

However, a constructive sale does not have to be reported if the transaction was closed before the 30th day after the end of your tax year and the appreciated financial position was held, unhedged, for at least 60 days afterwards. If a short sale is not closed by the 30th day of the following tax year, then it is deemed to have been closed on the earlier of either:

One thing to note is that you could buy stock against which you have a short position, but still not close out your position. In other words, the mere fact that you bought stock that you have also sold short does not automatically close out the short sale until the shares are delivered to the broker with the instructions to close the short sale. Nonetheless, tax law treats the acquisition of the stock while a short position is held in the same stock as a closing of the short sale, even if it was not actually closed out.

Under these rules, the constructive sale treats the short sale transaction as if you had sold your original shares, and then immediately bought them back. If you continued to hold the long position, then a new holding period begins when the short sale is closed out.

Example: On January 5, you buy 100 shares of XYZ stock for $5. On September 1, you sell short 100 shares of XYZ stock for $10 per share.

Case 1: You close your short position on January 23 of Year 2 for $8 a share. You continue holding your original 100 shares of XYZ stock until April 15, when you sold the stock for $12 per share, and you did not hedge your position with options or by any other method.

You earned $2 per share on your short sale and $7 per share on your long position, for a total profit of $900, both of which will be reported in Year 2.

Case 2: Same as Case 1, but you close your short position on February 3, Year 2. Therefore, because your short position was not closed by the 30th day after the end of your tax year, your short sale on September 1,  Year 1 is treated as a constructive sale in which you made a profit of $5 per share, or a total of $500 that must be reported for Year 1. The holding period for your long position now begins on February 3, Year 2 instead of January 5, Year 1 when you bought the original shares. You still earn a gain on your long position of $2 per share, but, the gain is short-term. Both, the gain on the short sale and the gain on the long position must be reported for Year 2. Note that the profit on your original stock is considered short term, even though you have held it for more than 1 year. You still earned $7 per share on the stock, but you had to report $5 of your gain in Year 1 and $2 of your gain in Year 2.

When the short sale is actually closed, then the gain or loss is equal to the short sale proceeds minus the applicable tax basis. Your broker will report the short sale on Form 1099-B, and the transaction is reported in the tax return on Form 8949, Sales and Other Dispositions of Capital Assets in the year that it was closed, even if settlement takes place in the next year.

Example: On January 17, you buy 100 shares of XYZ Corporation for $1000. On June 1, you sell short 100 shares of XYZ Corporation for $1500. On October 1, you close the short sale by buying 100 shares for $1200. You have a $300 short-term capital gain on the short sale. On March 1, you sell your original 100 shares for $2000. Your $1000 gain is a short-term capital gain because the holding period began when the short sale was closed out on October 1.

Puts. If you buy a put in which you also own the underlying stock, with a term of 1 year or less, then any gain is considered a short-term capital gain. This rule also applies if the underlying stock is purchased after buying the put but before the disposition of the put. In either case, the holding period for the underlying stock begins on the earliest date of:

However, if the put is purchased along with the underlying stock, and it is identified as being covered by the put, then the short sale rules do not apply. If the put expires worthless, then this cost is added to the basis of the stock.

Deductibility of Substitute Payments In Lieu Of Dividends

Because the shorted stock was sold, the lender of the stock no longer receives dividends paid by the corporation, but, instead, goes to the unknown buyer of the shorted stock. But since the lender of the stock is still entitled to dividends, the short seller must compensate the lender with what are called substitute payments in lieu of dividends. Generally, payments of dividends are deducted by the short seller by adding the amount to the basis of the re-purchased stock. However, if a short sale position is held for at least 46 days, then you can claim an itemized deduction of the payments as investment interest. In the case of extraordinary dividends, which are dividends that exceed the short sale proceeds of the common stock by 10%, or 5% for preferred stock, then the applicable holding period is 1 year. The stock must be held for at least 1 year in order to claim the dividends as itemized investment interest. Extraordinary dividends received from stock within an 85-day period are aggregated; however, if the dividends exceed 20% of the adjusted basis of the stock, then the dividends are aggregated over a 1-year period.