30.5 Short Sales of Stock

A short sale is a sale of stock borrowed from a broker. The short sale is closed when you replace the borrowed stock by buying substantially identical stock and delivering it to the broker or by delivering stock that you held at the time of the short sale. One objective of a short sale is to profit from an anticipated drop in the market price of the stock; another objective may be to use the short sale as a hedge.

Tax rules applied to short sales are designed to prevent you from:

  • Postponing gain to a later year when you sell short while holding an appreciated position in the same or substantially identical stock. This type of short sale is called “a sale against the box.”
  • Converting short-term gains to long-term gains.
  • Converting long-term losses to short-term losses.

Year in which gain on short sale is realized.

Generally, you report gain on a short sale in the year in which you close the short sale by delivering replacement stock. However, if you execute a short sale while holding an appreciated position in the same stock (short sale against the box) or substantially identical stock is acquired to close an appreciated short position, the short sale or acquisition of substantially identical stock is treated as a constructive sale of an appreciated financial position (30.8) and you must report the transaction in the year of the constructive sale, even though delivery of replacement stock is made in a later year; see Examples 2 and 3 below. There is this exception to the constructive sale rule: The short sale is reported in the year of delivery of the replacement stock if (1) you close the short sale before the end of the 30th day of the next year, (2) you continue to hold a similar position in the stock for at least 60 days after the closing of the short sale, and (3) your risk of loss during the 60-day period was not reduced by other positions.

If the stock sold short becomes worthless before you close the short sale, you recognize taxable gain in the year the shares became worthless.

EXAMPLES
1. On May 4, 2012, you buy 100 shares of Auto Corp. stock for $1,000. On September 14, 2012, you borrow 100 shares of Auto Corp. from your broker and sell them short for $1,600. You make no subsequent transactions involving Auto Corp. stock. The short sale is treated as a constructive sale of an appreciated financial position because a sale of your Auto Corp. stock on September 14, the date of the short sale, would have resulted in a gain. You have a $600 short-term capital gain from the constructive sale and you have a new holding period for your Auto Corp. stock that begins on September 14, 2012.
2. In January 2012 you buy 100 shares of Steel Co. stock for $1,000 (100 × $10). In November 2012 when the stock is selling at $50, you execute a short sale of 100 shares (100 × $50 = $5,000). In February 2013, you deliver your shares to close the short sale. The tax law treats the short sale as a constructive sale of an appreciated financial position because a sale of your Steel Co. stock on the date of the short sale would have resulted in a gain. You report the gain of $4,000 ($5,000 − $1,000) in 2012, the year of the short sale, not in 2013 when you close the sale. To shift tax reporting to 2013, you would have had to close the short sale by the 30th of January and obtain similar stock, which you would have had to hold for at least 60 days after the closing of the short sale. Also see Example 3 and 30.8 for further details on constructive sales.
3. A taxpayer who does not own any shares of XYZ stock directs his broker in January of Year 1 to sell short borrowed XYZ shares. On December 31 of Year 1, when the value of XYZ shares has decreased, the taxpayer directs the broker to close the short sale by purchasing XYZ shares in a “regular-way” sale, with actual delivery of the shares taking place at the beginning of Year 2. The IRS ruled that the short position is an appreciated financial position as of December 31, given the decrease in the stock price since the short sale. The purchase of replacement shares on December 31 is a constructive sale of the appreciated position. Gain is taxable in Year 1, not in Year 2 when the shares were delivered.

Short-term or long-term gain or loss.

Whether you have short-term or long-term capital gain or loss generally depends on your holding period for the property delivered to the broker to close the short sale. Furthermore, you must apply Rules 1 and 2 below if you answer “yes” to either of the following questions:

1. When you sold short, did you or your spouse hold for one year or less securities substantially identical to the securities sold short? (Substantially identical securities are described at 30.6.)
2. After the short sale, did you or your spouse acquire substantially identical securities on or before the date of the closing of the short sale?

Rule 1. Gain realized on the closing of the short sale is short term. The gain is short term regardless of the period of time you have held the securities as of the closing date of the short sale.

Rule 2. The beginning date of the holding period of substantially identical stock is suspended. The holding period of substantially identical securities owned or bought under the facts of question (1) or (2) does not begin until the date of the closing of the short sale (or the date of the sale, gift, or other disposition of the securities, whichever date occurs first). But note that this rule applies only to the number of securities that do not exceed the quantity sold short.

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image Planning Reminder
Puts
The acquisition of a put (an option to sell) is treated as a short sale if you hold substantially identical securities short term at the time you buy the put. If you have held the underlying stock for one year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration. Your holding period for the underlying stock begins on the earliest of: (1) the date you dispose of the stock; (2) the date you exercise the put; (3) the date you sell the put; or (4) the date the put expires. However, the short-sale rules do not apply if on the same day you buy a put and stock that is identified as covered by the put. If you do not exercise the put that is identified with the stock, add its cost to the basis of the stock.
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Losses.

A loss on a short sale is not deductible until shares closing the short sale are delivered to the broker. You may not realize a short-term loss on the closing of a short sale if you held substantially identical securities long term (that is, for more than a year) on the date of the short sale. The loss is long term even if the securities used to close the sale were held for one year or less. This rule prevents you from creating short-term losses when you held the covering stock long term. Loss deductions on short sales may be disallowed under the wash-sale rules in 30.6.

EXAMPLES
1. On February 2, 2012, the stock of Oil Co., which you do not own, is selling at $90 per share. You expect the price to fall over the next year and sell short 500 shares borrowed from your broker for $45,000 (500 × $ 90). However, 13 months later, on March 12, 2013, after the price has risen to $110, you close the short sale by buying 500 shares of Oil Co. stock ($500 × $110 = $55,000 cost) and immediately delivering them to your broker. Your loss of $10,000 ($55,000 − $45,000) is treated as a short-term capital loss because your holding period for the delivered stock is less than one day.
2. On February 10, 2012, you buy 100 shares of Tech Corp. stock for $1,000. On July 13, 2012, you sell short 100 shares of Tech Corp. for $1,600. You close the short sale on November 16, 2012, by buying 100 shares for $1,800 and delivering them to your broker. On the short sale, you realize a $200 short-term capital loss.
On February 22, 2013, you sell for $1,900 your original lot of Tech Corp. stock bought on February 10, 2012. Although you have held these shares for more than one year, the $900 gain realized on the sale is treated as a short-term capital gain under Rule 2 above. Rule 2 applies because on the date of the short sale, the February 10 shares were held short term (one year or less). Under Rule 2, the holding period of the February 10 lot is considered to begin on November 16, 2012, the date the short sale was closed.

Expenses of short sales.

Before you buy stock to close out a short sale, you pay the broker for dividends paid on stock you have sold short. If you itemize deductions, you may treat your payment as investment interest (15.10), provided the short sale is held open at least 46 days, or more than a year in the case of extraordinary dividends. If the 46-day (or one-year) test is not met, the payment is generally not deductible and is added to basis; in counting the short-sale period, do not count any period during which you have an option to buy or are obligated to buy substantially identical securities, or are protected from the risk of loss from the short sale by a substantially similar position.

Under an exception to the 46-day test, if you receive compensation from the lender of the stock for the use of collateral and you report the compensation as ordinary income, your payment for dividends is deductible to the extent of the compensation; only the excess of your payment over the compensation is disallowed. This exception does not apply to payments with respect to extraordinary dividends.

An extraordinary dividend is generally a dividend that equals or exceeds the amount realized on the short sale by 10% for any common stock or by 5% for any preferred stock dividends. For purposes of this test, dividends on stock received within an 85-day period are aggregated; a one-year aggregation period applies if dividends exceed 20% of the adjusted basis in the stock.

Arbitrage transactions.

Special holding period rules apply to short sales involved in identified arbitrage transactions in convertible securities and stock into which the securities are convertible. These rules can be found in Treasury regulations to Internal Revenue Code Section 1233.

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