A recent

Dear Dagen column discussed a trading strategy called "shorting against the box" and mentioned that the

Internal Revenue Service

had cracked down on the practice.

Many of you wrote in begging to know more about the tax implications of this strategy.

You've come to the right place. In this special edition of the Tax Forum, we'll dissect -- and hopefully help you digest -- the intricate tax rules surrounding this strategy.

Be warned, though: This is tough stuff. So pour yourself a cup of coffee and settle in.

And if you have any other trading-related tax questions, be sure to send them to

taxforum@thestreet.com. Please include your full name.

The Basics

Investors have been shorting against the box for years. It's a great way to protect gains in an individual stock, and it used to be an easy way to defer capital-gains tax.

When you short against the box, you lock in profits on a stock you already own by borrowing an equivalent number of shares of the same stock through your broker and selling them short. Later on, you'll buy back the shares and repay the broker.

Now you've neutralized your position. If the stock falls, you'll profit on your short position and lose out on your long position (at least on paper). If the stock rises, the opposite occurs. You're unaffected by changes in the stock's price, plus you get to use the cash you generated selling the borrowed shares of stock.

"People short against the box when they think the market is going to take temporary dip but don't want to sell their long position," says Gail Winawer, tax securities partner at

American Express Tax & Business Services

in New York.

On top of it all, before 1997, you did not have to report any capital gains or losses until the position was closed out -- meaning you delivered the stock to close out your short position. So as long as the position was open, you could defer taxes on this trade indefinitely.

No surprise, this tax perk was abused. Say an investor owned stock that had a basis of 20, but the stock was trading at 100. He could lock in that gain by shorting against the box and put off the taxes practically forever.

After his death, his heirs would receive the stock with an automatic step-up in basis. That means his beneficiaries would inherit the stock at a cost basis of 100, sell it at the current trading price and would owe minimal, if any, capital-gains tax.

"Everyone was having their cake and eating it, too," notes Winawer, citing the highly publicized

Estee Lauder

(EL) - Get Report

case as an example. Back in 1995, the makeup mogul and her family avoided taxes on an estimated $125 million gain as a result of this technique.

The Taxpayer's Relief Act of 1997 changed all this.

Now when you short against the box, you create a taxable event the day you create the short. So for tax purposes, you must "construct" a sale -- hence, the constructive sale rule.

This rule says you must pretend to sell your long shares for the same amount of the short, says Winawer. Say your 20-basis shares are now worth 100. If today you sell shares short against the box at 100, you would be required to report a capital gain of 80 on each long share on your 1999 tax return -- even though you haven't closed out your short position.

"Although

the long sale didn't really happen, it was deemed to happen for tax purposes," says Ted Tesser, author of

The Trader's Tax Survival Guide

.

But there's a way to prevent this "constructive" mess.

You first must close out your short position by the 30th day after the end of the tax year in which the transaction occurred, says Tesser. For most investors, this would be Jan. 30 of the following year. But for those of you whose tax year ends on, say, June 30, you'd have to close the position by July 30.

Then, beginning on the day the short position is closed, you must hold the original long position for at least another 60 days. This must be a "hold naked" position for the entire 60 days. That means you can't use options to reduce your risk on these shares in any other way.

So if you sell short against the box in January, you can hedge yourself for nearly 13 months, maximum, as long as you're willing to be unhedged for another 60 days after that.

"The idea here is that the IRS is trying to eliminate riskless transactions," notes Tesser.

By avoiding the constructive sale rule, you won't have to report any gain on your long position until you sell the stock. But you will have to report gains, if any, on the short position you closed out.

Whew.

Holding-Period Adjustment

Note that shorting against the box may also adjust the holding period of your long shares. Although this holding-period adjustment has been around for as long as the technique has, many people are still not aware it exists.

The holding period is the length of time you've held the stock, and it helps you determine whether your gain or loss is short-term or long-term for tax purposes. If you've held the long shares less than 12 months, your holding period will be

erased

if you go short against the box. That means you'll have to hold the long shares another 12 months to qualify for long-term capital-gains treatment.

If you've held the stock for more than 12 months, shorting against the box will not affect the existing holding period.

"These rules are a mess," says Winawer. But until we get more guidance from Uncle Sam, they are what you have to deal with to avoid unnecessary capital gains.

Hot Around Collars

Since there's no longer a tax perk to shorting against the box, more investors are using collar transactions as a hedge. A collar is another way of hedging your long stock position using opposing calls and puts. Check out this previous

Options Buzz for more on collars.

TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.

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