Sometimes rules were meant to be broken.

If you were savvy enough to protect a favorite holding by going

short against the box last year, you have until Jan. 30 to close out the short position. Otherwise, you'll owe tax on your 2000 tax return on any gains that your long position had on the day you created the short.

But if you watched that darling holding take a serious dip, you may be better off paying the tax.

First, a warning: This strategy is not for the weak-hearted. This is tough stuff. So pour yourself a cup of coffee and settle in as we walk through the details.

Let's assume that back in March, your 200 shares of

Microsoft

(MSFT) - Get Microsoft Corporation (MSFT) Report

, a.k.a. your long position in Mister Softee, had a big gain. You knew, though, that the shares were going to get smacked thanks to the

Justice Department

court battles. You decided to protect your gains and went "short against the box." (In the old days, people used to hold their stock certificates in safety-deposit boxes -- so they were short against the shares in that box. Get it?)

You told your broker to sell short 200 shares of Microsoft. That means you borrowed the shares from your broker and sold them, knowing that later you'd have to buy back the shares (hopefully at a lower price) and repay your broker.

By doing this, you neutralized your position. If the stock fell, you'd profit on your short position and lose out on your long position (at least on paper). If the stock rose, the opposite would occur. You essentially would be unaffected by changes in the stock's price, plus you'd get to use the cash you generated selling the borrowed shares of stock.

The bigger perk would be that you delayed paying any tax on those shares for a bit because you no longer had to sell those long shares to salvage that gain.

Well, sort of.

Thanks to the

Internal Revenue Service's

constructive sale rule, when you short against the box, you create a taxable event the day you create the short. That means, for tax purposes, you must "construct" a sale.

This rule says you must pretend to sell your long shares for the same amount of the short. Let's say a few years ago you bought your Microsoft shares at $10 (that's your cost basis) and they were worth $110 on the day you decided to sell shares short against the box. The constructive sale rule would require you to report a capital gain of $100 on each long share on your 2000 tax return.

Fortunately, there's a two-step process to prevent this "constructive" mess and avoid paying that long-term gain in 2000.

You first must close out your short position by the 30th day after the end of the tax year in which the transaction occurred. For most investors, this would be Jan. 30 of the following year. Because a short sale is not closed until it settles, the

settlement date is the date that counts for tax purposes. So you have until Jan. 26 to complete this trade, reminds Gail Winawer, a tax securities partner at

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American Express Tax & Business Services

. That allows the trade a few days to settle.

Then, beginning the day the short position is closed (Jan. 30), you must hold the original long position "naked" for at least another 60 days. That means you can't use options or shorts to reduce your risk on these shares.

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

In a case where your stock took a minor dive and then came back up, this could be a great strategy, especially if you closed the short just as the stock turned north.

But if, thanks to this volatile market, the gain in your long shares was cut in half, closing out the short actually could increase your tax liability, says Jeffrey Chazen, a manager at

Richard A. Eisner

, the eighth-largest accounting firm in New York.

In our example, Microsoft was trading at $110 on the day you created a short position. Your long-term gain in Microsoft, then, was $100. At the 20% long-term capital gains rate, you now owe $20 in long-term capital gains tax on your 2000 tax return.

Now in January 2001, the stock falls to $50 and your long-term gain is down to $40. On the flip side, your short position is up $60.

To avoid that long-term capital gain hit in 2000, the constructive sale rule says that you must close your short position by Jan. 30, 2001. In that case, you'll end up with a short-term gain of $60, taxed at your ordinary income rate. At the highest federal rate of 39.6%, that's about $24 in tax.

Remember, you still need to hold your long shares naked for 60 days. Assuming the stock holds at $50, you'll owe another $8 ($40 x 20%) in long-term capital gains tax if you decide to sell 60 days later. So you've increased the tax burden by more than 50%, says Chazen.

If you don't sell your long position at the end of 60 days, the stock may go back up and you'll just owe more tax when you sell.

But with the current market conditions, it may not be worth it to hold naked for 60 days, says Winawer. So instead you decide not to close the short. You'd end up with a constructive sale and would owe $20 in 2000. Just be aware that the interest on that borrowed stock is tallying while your short position is open. Later, when you close the short, it's a nontaxable event because you essentially paid the tax bill in 2000, says Chazen. That means you're saving yourself tax dollars in this case.

So before you jump to close out your short position by Jan. 30 to avoid the constructive sale rule, be sure to analyze your tax situation. Do you have a position where the short-term gain on the short position is approaching or equal to your original long-term gain? If so, you may not want to close out the short. You may be better off letting the constructive sale rule kick in.

Every situation is different, so be sure to explore all the different scenarios. "But this is something that an investor should consider with volatile stocks over a period of time," says Richard Shapiro, an

Ernst & Young

securities tax partner in New York.

Remember, though, all rules aren't good for all people.

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