Short-Selling Gets Sticky at Year-End

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.

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