An Individual investor who engages in the practice of short-selling stock encounters several complex reporting issues when it comes time to prepare their individual income tax return. Investors who sell short stock believe the price of the underlying security value is going to decline. Typically, a brokerage firm lends the investor the underlying stock and it is then sold and converted to cash. The investor is charged margin interest on the value of the borrowed securities. If the stocks pay a dividend, the investor is required to pay over the dividend to lender or broker.
For example, 100 shares Company XYZ, Inc. are sold short at $60 per share, the investors borrows the shares and immediately sells them for $6,000. As hoped, the shares decline to $40 per share resulting in a profit a $20 per share. The investor covers the position by buying the shares at $40 and delivering the securities back to lender for a gain to the account of $2,000. The short seller loses money when the price of the shares goes up and is open to potentially unlimited losses until the position is closed.
The holding period of the securities used to cover determines whether the gain or loss is reportable as short-term or long-term. However, special holding period rules apply to prevent taxpayers from using short sales to convert short-term gains into long-term gains and long-term losses to short-term losses. If on the date of the short sale the investor owns or acquires substantially identical property before closing the short any gain is deemed short-term regardless of how long the underlying securities used to cover the position have been held. If on the date of the short sale the underlying security used to cover was held more than one year any loss from the short sale will be deemed to be long term regardless of the holding period of the securities used to cover.
When the short-sale transaction is closed, the sale is reported on Form 8949, Sale and Other Disposition of Other Assets, If the 1099-B issued by the broker shows the short sale proceeds in a tax year other than the year gain or loss is properly recognized it is necessary to reconcile the difference between amounts reported on the Form 1099-B and the proceeds shown on Form 8949.
The margin interest paid on the loan is a deductible as an itemized deduction as investment interest expense reportable on Form 4952, Investment Interest Expense Deduction, subject to the limit of investment income.
Investors also need to be careful to avoid constructive sale rules requiring the recognition of gain at the time of the short sale and not the time of the close of transaction.
When a dividend is paid on a stock that is sold short, the short seller must make a payment in lieu of dividends to the lender. The payment is deductible investment interest expense to the extent of investment income. If the short position is closed within 45 days in lieu of dividend payment is not deductible, but is added to the basis of the stock used to close the short sale.
Wash sale rules also apply to short sale loss transactions when another short sale of the same security is entered into within 30 days after the closing of the sale given rise to a loss. The loss will be deferred and added to the basis of the second transaction. The wash sale rule is the same whether it is a short sale or long sale.
When entering into short sale transactions, Investors need to pay close attention to complex tax reporting requirements. Should you realize such transactions, please follow up with your Marcum Tax Professional for guidance.
