IRS pub 550
Quickfinder – Schedule D section
Can you explain what a short sale is?
A short sale is when a taxpayer sells borrowed securities and repays the lender at a later date with substantially identical property.
Strategy in use: Albert currently owns XYZ stock which is trading at $50 per share. John thinks XYZ stock is going to go down and wants to profit off that. John borrows Albert’s shares and then sells them to an investor who wants to purchase the shares. 6 months go by and XYZ stock has dropped to $30 per share. John buys the shares from the open market and delivers the shares to Albert, thus paying off what he owes Albert. The end result is John made a $20 profit.
What are the tax consequences of a short sale?
Taxation of a short sale occurs when the transaction is closed which is when the taxpayer delivers the replacement property to the lender. The taxpayer has a capital gain if the shares have decreased when the replacement property is purchased. If the price of the property increase, the taxpayer has a capital loss.
How do I determine if a short sale is a long-term or short-term capital gain?
The holding period of the securities used to close the short sale generally determines whether the gain is short-term or long-term.
What is shorting against the box?
Short selling against the box is either short selling securities you already own or buying a put option on stock you have a long position in. This strategy is used to “lock in” gains on “appreciated financial positions” without immediate recognition of taxable income.
What are the tax ramifications of shorting against the box?
Unless certain requirements are met, shorting against the box will result in what is called a constructive sale. The asset the investor already holds is considered sold on the date the securities were sold short and any capital gain would have to be realized.
Important: Please see the next question for the exception to this rule
Example: John owns 100 shares of XYZ stock with a basis of $30 and it is currently trading at $70 per share. John decides to short sell 100 shares to another investor by borrowing 100 shares from Albert. John is treated as selling the 100 shares he already owns which will result in a $40 capital gain.
Are there any exceptions to the constructive sale rules?
The constructive sale rules do not apply if the following conditions are met:
You closed the transaction on or before the 30th day after the end of your tax year
You held the appreciated financial position throughout the 6-day period beginning on the date you closed the transaction.
Your risk of loss was not reduced at any time during that 60day period by holding certain other positions.