Ask Bev: How Can I Minimize Tax on Year-End Short Trades?

A few days can have big implications when the obligation comes due.
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Beverly,I'm currently short several stocks -- closing out some positions will result in a gain, but I wasn't so lucky in others. Should I wait until the new year to close these positions or do it now? Can I use the loss to offset the gain? When do I need to complete the transactions to have it count for this tax year?

-- Ron W.

Well, the short answer (sorry, couldn't resist) is that the timing is very sensitive in closing out short positions at year's end. Closed positions that will result in a gain are considered closed on the date of the initial transaction, while positions that will result in a loss aren't considered closed until the replacement shares are delivered. In either case, the gains and losses from short sales can be used to offset one another. (For more rules on how to match up capital gains and losses, see

this story.)

For the uninitiated, 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 is trickier at year-end, because the rules for when gains are triggered are different from the rules for when losses are triggered. Investors hoping to delay reporting a gain or accelerate reporting a loss must be aware of these distinctions.

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.

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 shares of

National Semiconductor

(NSM)

on Dec. 1 on the assumption its share price was headed south. By Dec. 26 of this year, the stock has indeed dropped 12.1%, which means you have a gain on your short position.

If you close out your position today, the IRS will mark Dec. 30 as the date on which you incurred the gain --

not

Jan. 5, 2004, 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 the year in which you pay tax on the gain or are able to deduct the loss.

So 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, 2004, before you purchase the replacement shares.

But the strategy is the exact opposite for the positions in which you've incurred a loss.

Let's say that you also shorted

Intuit

(INTU) - Get Report

on Dec. 1. This time, you bet wrong -- despite its recent sharp run-up, its share price continued to rise another 4.8% since then, 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 2003 (which you can use to set off any long-term capital gains, short-term capital gains -- such as those from other short sales -- 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, 2003. 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. And sadly, it's likely too late for that this year.

In case you're looking for a little logic behind this seeming discrepancy, here you go: The difference in tax treatment is because of the "constructive sale" rule that was 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. Aware of the confusion in this area, the IRS issued guidance last year on when a gain or loss is triggered on short sales, but the rules are actually 6 years old.