Taxation of Short Sales

A short sale occurs when stock is borrowed from a broker to sell in the market, hoping to profit by buying it back later at a lower price. Short sales are a means to profit from market downturns or to hedge a position. Though a short sale resembles the reverse of buying a stock, hoping to profit from an increase in stock price, the tax rules for short sales differ from long sales.

Tax law treats covered short sales differently from uncovered short sales. A covered short sale is one in which you own substantially identical securities, including not only the stock itself, but also call or put options in which the stock is the underlying asset, or any security convertible into the stock, such as convertible bonds, or other property hedging 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, owns substantially identical securities. An uncovered short sale is one 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 to close out 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.

If the property was held for longer than 1 year, then the gain or loss is long-term; otherwise it is short-term.
If the property was not used to close a short sale, then a new holding period for the property begins when the short sale is closed, but only for the number of shorted shares.
A covered short sale closed out at a loss is always a long-term loss regardless of how long the substantially identical property was held, even if the property used to close the sale was held for less than 1 year.

Example: How a Short Sale of Stock Already Owned Affects the Holding Period

January 10: buy 100 shares of JXYZ corporation.
October 4: sell short 50 shares of JXYZ corporation.
October 25: buy 50 shares from the market and instruct the broker to close out the short position.
March 8: sell the original 100 shares of JXYZ Corporation.

The holding period for 50 of the shares began when the shares were bought on January 10, resulting in a long-term gain or loss, but the holding period for the remaining 50 shares began when the short sale was closed, so the gain or loss on those shares is short-term.

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

Example: Determining Whether a Short Sale Was Long-Term or Short-Term

January 5: sell short 100 shares of ABC stock for $10 a share.
March 6 of the next year: buy 100 shares of ABC stock for $5 a share to deliver to the broker to replace the borrowed shares, thereby closing out the short position.
Because the shares used to replace the borrowed shares was held for less than 1 day, the 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, tax law treats the sale as a constructive sale, even though you did not technically close out your position. Gain is based on the short sale proceeds, and a new holding period for the original stock begins on the short sale date. If the price received on the shorted stock is less than the tax basis of the your long position, a gain or loss is reported when the short position is closed. If the shares of stock become worthless before the sale is closed, the gain is recognized when the shares become worthless.

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

on the short sale date if the securities were already owned; or
on the acquisition date of substantially identical securities.

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, 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: Determining Whether a Gain or Loss Is Short-Term or Long-Term Holding Long and Short Positions of the Same Stock

January 5: buy 100 shares of JXYZ stock for $5.
September 1: sell short 100 shares of JXYZ stock for $10 per share.

Case 1:

January 23, Year 2: close the short position for $8 a share.
April 15, Year 2: sell the original 100 shares of JXYZ stock for $12 per share. The position was not hedged with options or by any other method.
total profit: $900, which will be reported for Year 2.
- short sale profit: $2 per share
- long position profit: $7 per share

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 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, the gain or loss = 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 when closed, even if settlement occurs in the next year.

Example: How a Short Position Can Change the Holding Period for a Long Position in the Same Stock

January 17: buy 100 shares of JXYZ Corporation for $1000
June 1: sell short 100 shares of JXYZ Corporation for $1500
October 1: close the short sale by buying 100 shares for $1200
- short-term capital gain on the short sale: $300
March 1: sell the original 100 shares for $2000
- The $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 with a term of 1 year or less in which you also own the underlying stock, 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:

the disposition of the stock;
the exercise of the put;
the sale of the put; or
when the put expires.

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 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.