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.
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.