Short-Selling Gets Sticky at Year-End
Beverly Goodman
12/23/02 - 02:45 PM EST
Short-selling is a tricky business -- and this time of year the Internal Revenue Service makes it a little trickier.
Selling shares short means an investor is betting that the share price will drop. Through a broker, an investor borrows shares of a company and sells them immediately. Ideally, the share price falls and the investor can purchase the same amount at a much cheaper price. The new shares are then returned to the borrower and the investor pockets the difference. If the share price actually rises, the investor will likely be forced to pay more to buy the replacement shares, and therefore incurs a loss on his or her investment.
Because share prices can theoretically rise infinitely, short-sellers take on more risk than those who invest long (when you invest long, you can't lose more than you invest, because share prices can't fall below zero).
Short-selling isn't the evil, anti-American practice many claim it is. But frankly, if you need a definition of short-selling, you probably shouldn't do it.
Short-selling is trickier at year-end because the rules for when gains are triggered are different than the rules for when losses are triggered. Investors hoping to delay reporting a gain or accelerate reporting a loss need to be aware of these distinctions.
The rules are not new per se, but the IRS issued guidance earlier this year on when a gain or loss is triggered on short sales. "The rules were in the 1997 tax act, but little noticed at the time," says Jim Seidel, a senior tax analyst at RIA, a provider of tax information and software to tax professionals. "The IRS wanted to give the rules a higher visibility this year, though."
In short (sorry, pun intended), the gain on a short position is triggered as soon as the stock that will be used to cover the short position is purchased. That means the gain is triggered
before the short sale is actually closed -- in other words, before the replacement shares are delivered to the lender.
Losses on short sales, though, aren't officially incurred until the position is fully closed out.
Timing is Everything
Clearly, these rules don't have any impact on short sales closed throughout the year. But when trying to delay gains or accelerate losses in the last few days of the year, the three days it typically takes to close out a position can be crucial.
Let's look at two examples -- one in which the short sale results in a gain, and another in a loss.
Say you directed your broker to borrow and sell 100 shares of
Microsoft (MSFT - Cramer's Take - Stockpickr) in March on the assumption its share price was headed south. By Dec. 30 of this year, the stock has indeed dropped in value, which means you have a gain on your short position.
As soon as you purchase shares of Microsoft, the IRS will mark (in this example) Dec. 30 as the date when you incurred the gain -- not Jan. 4, 2003, the likely time the shares would be delivered to the original lender and the short position officially closed out. The three- or four-day transaction time doesn't matter in most cases, but at the end of the year it can determine in which year you pay tax on the gain or are able to deduct the loss.
For instance, if you want to delay the gain into the next tax year (giving yourself another 16 months to pay the tax), you'll have to wait until Jan. 1, 2003 before you purchase the replacement shares -- not how long you think it will take to actually close out the position.
While short-sellers who want to delay paying tax on any gain should wait until the new year before even beginning the process of closing their position, the advice is the exact opposite for short-sellers that have incurred a loss.
But now let's say that you had the bright idea to short Microsoft in July instead of March. This time, you bet wrong -- Microsoft's share price has gone up since July, which means you'll have to purchase the replacement shares for more money than you got from selling them. The price difference is your loss.
But in order to claim that loss in 2002 (which you can use to set off any long-term capital gains, short-term capital gains or up to $3,000 of ordinary income), you need to fully close out your short position. That means you need to buy the replacement shares and deliver them to their original owner by Dec. 31, 2002. Unlike gains, losses on short sales aren't official in the eyes of the IRS on the trade date -- the loss is recorded on the settlement date.
Think Ahead
So if you're looking to claim a loss for this year, make sure you begin to close your position early enough that the settlement date still falls in 2002.
The difference in tax treatment is because of the "constructive sale" rule slipped into the 1997 tax law. The rule applies to the sale of an appreciated position -- because losses by definition mean there's no appreciation, they're governed by a different set of rules.
And although the tax code contains no shortage of rules, the ones for year-end short positions are simple: Hold off on closing out appreciated positions until 2003, and make sure you allow enough time to completely close positions that incur a loss. Once you've avoided any surprises the tax code has in store, you can turn your attention to less taxing matters -- like the pleasant surprises the holidays have in store.
