(including new rules for substitute payments)

1. You sell short. You borrow property and deliver it to a buyer.
    
2. You close the sale. At a later date, you either buy substantially identical property and deliver it to the lender or make delivery out of property that you held at the time of the sale.  Delivery of property borrowed from another lender does not satisfy this requirement.

You do not realize gain or loss until delivery of property to close the short sale.

Exception if property becomes worthless. A different rule applies if the property sold short becomes substantially worthless. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.

Exception for constructive sales. Entering into a short sale may cause you to be treated as having made a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. For details, see Constructive Sales of Appreciated Financial Positions below.

Example. On May 3, 2005, you bought 100 shares of Baker Corporation stock for $1,000. On September 3, 2005, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2005 and the first 30 days of 2006. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale.


General Summary: When closing short sale transactions at a loss, pursuant to Regs. §1.1233-1(a)(1), the settlement date is the delivery date, the date on which the actual security or cash changes hands.  The settlement date marks the closing date for tax reporting.  Do not use trade date for the closing end of the transaction at a loss.

Conversely, pursuant to Code §1259(b) and §1259(c), under the "constructive sales of appreciated financial positions exception" when closing short sale transactions at a gain, the trade date is the "deemed delivery date."  The trade date marks the closing date for tax reporting.  Do not use settlement date for the closing end of the transaction at a gain. (as clarified in Rev. Rul. 2002-44)

Short-Term or Long-Term Capital Gain or Loss
As a general rule, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount of time you actually hold the property eventually delivered to the lender to close the short sale.

Example. Even though you do not own any stock of the Ace Corporation, you contract to sell 100 shares of it, which you borrow from your broker. After 13 months, when the price of the stock has risen, you buy 100 shares of Ace Corporation stock and immediately deliver them to your broker to close out the short sale. Your loss is a short-term capital loss because your holding period for the delivered property is less than one day.

Special rules. Special rules may apply to gains and losses from short sales of stocks, securities, and commodity and securities futures (other than certain straddles) if you held or acquired property substantially identical property to that sold short. But if the amount of property you sold short is more than the amount of that substantially identical property, the special rules do not apply to the gain or loss on the excess.

Gains and holding period. If you held the substantially identical property for 1 year or less on the date of the short sale, or if you acquired the substantially identical property after the short sale and by the date of closing the short sale, then:

• Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain, and
   
• Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.

Losses. If, on the date of the short sale, you held substantially identical property for more than 1 year, any loss you realize on the short sale is a long-term capital loss, even if you held the property used to close the sale for 1 year or less. Certain losses on short sales of stock or securities are also subject to wash sale treatment. For information, see Wash Sales, later.

Mixed straddles. Under certain elections, you can avoid the treatment of loss from a short sale as long term under the special rule. These elections are for positions that are part of a mixed straddle. See Other elections under Mixed Straddles, later, for more information about these elections.
Reporting Substitute Payments

If any broker transferred your securities for use in a short sale, or similar transaction, and received certain substitute dividend payments on your behalf while the short sale was open, that broker must give you a Form 1099-MISC or a similar statement, reporting the amount of these payments. Form 1099-MISC must be used for those substitute payments totaling $10 or more that are known on the payment's record date to be in lieu of an exempt-interest dividend, a capital gain dividend, a return of capital distribution, or a dividend subject to a foreign tax credit, or that are in lieu of tax-exempt interest. Do not treat these substitute payments as dividends or interest. Instead, report the substitute payments shown on Form 1099-MISC as "Other income" on line 21 of Form 1040.

Substitute payment. A substitute payment means a payment in lieu of:

1. Tax-exempt interest (including OID) that has accrued while the short sale was open, and
    
2. A dividend, if the ex-dividend date is after the transfer of stock for use in a short sale and before the closing of the short sale.

If you borrow stock to make a short sale, you may have to remit to the lender payments in lieu of the dividends distributed while you maintain your short position. You can deduct these payments only if you hold the short sale open at least 46 days (more than 1 year in the case of an extraordinary dividend as defined below) and you itemize your deductions.  (IRS Publication 550)   As stated in IRS Publication 550, Investors deduct these payments as investment interest on Schedule A.  But active Traders generally deduct these payments as operating interest on Schedule C, or equivalent.  Passive Traders (investing in a hedge fund, for instance) have a more complex method of deduction.

If you close the short sale by the 45th day after the date of the short sale (1 year or less in the case of an extraordinary dividend), you cannot deduct the payment in lieu of the dividend that you make to the lender. Instead, you must increase the basis of the stock used to close the short sale by that amount.  (IRC §263(h)(1)(B))
To determine how long a short sale is kept open, do not include any period during which you hold, have an option to buy, or are under a contractual obligation to buy substantially identical stock or securities. (IRC §263(h)(4)(A))

If your payment is made for a liquidating distribution or nontaxable stock distribution, or if you buy more shares equal to a stock distribution issued on the borrowed stock during your short position, you have a capital expense. You must add the payment to the cost of the stock sold short.

Exception. If you close the short sale within 45 days, the deduction for amounts you pay in lieu of dividends will be disallowed only to the extent the payments are more than the amount that you receive as ordinary income from the lender of the stock for the use of collateral with the short sale. This exception does not apply to payments in place of extraordinary dividends.  (IRC §263(h)(5))

Extraordinary dividends. If the amount of any dividend you receive on a share of preferred stock equals or exceeds 5% (10% in the case of other stock) of the amount realized on the short sale, the dividend you receive is an extraordinary dividend.  (IRC §1059(c)(2))
 

New for 2003:
On the flip-side, the party receiving the substituted payment, does not receive a dividend.  Rather, the party who's stock was borrowed receives a payment in lieu of a dividend.  This has been the case since 1960 per Internal Revenue Ruling 60-177, but prior to 2003 it was difficult, if not impossible, for most stockholders to learn if they received a dividend or if they received a payment in lieu of a dividend.  Brokers invariably reported these substituted payments on form 1099-DIV, box 1 rather than where they belonged: on form 1099-MISC, box 8.

The significance in the past being that a substituted payment is taxable at ordinary rates, whereas a capital gain dividend, or a return of capital dividend, for just two examples, were not supposed to be taxed in the same manner.

For 2003 the IRS has started to take action to force Wall Street to better inform shareholders of what type of payments they are receiving.  This has happened because of the new 15% tax rate on ordinary dividends has made the potential abuse far more widespread.

As these new reporting requirements came into effect, some shareholders were surprised to learn that they are being taxed at ordinary rates for payments in lieu of dividends, rather than preferential lower tax rates for dividend payments.

These newly enforced rules are for the shareholder (with long positions) and they do not necessarily effect the party that borrowed (shorted) the stock.

But it is possible that there will be a backlash when long position shareholders are faced with tax rates approaching 35% rather than an expected 15%.  Short sellers may need to pay a premium to the long position shareholders on top of the foregone dividends to compensate them for the difference in income tax rates they will be required to pay.

 

Reporting Substitute Payments
If any broker transferred your securities for use in a short sale, or similar transaction, and received certain substitute dividend payments on your behalf while the short sale was open, that broker must give you a Form 1099-MISC or a similar statement, reporting the amount of these payments.

Form 1099-MISC must be used for those substitute payments totaling $10 or more that are known on the payment's record date to be in lieu of an exempt-interest dividend, a capital gain dividend, a return of capital distribution, or a dividend subject to a foreign tax credit, or that are in lieu of tax-exempt interest. Do not treat these substitute payments as dividends or interest. Instead, report the substitute payments shown on Form 1099-MISC as "Other income" on line 21 of Form 1040.

Substitute payment. A substitute payment means a payment in lieu of:
1. Tax-exempt interest (including OID) that has accrued while the short sale was open, and

2. A dividend, if the ex-dividend date is after the transfer of stock for use in a short sale and before the closing of the short sale.

Payments in lieu of dividends. If you borrow stock to make a short sale, you may have to remit to the lender payments in lieu of the dividends distributed while you maintain your short position. You can deduct these payments only if you hold the short sale open at least 46 days (more than 1 year in the case of an extraordinary dividend as defined below) and you itemize your deductions.

You deduct these payments as investment interest on Schedule A (Form 1040). See Interest Expenses in chapter 3 for more information.

If you close the short sale by the 45th day after the date of the short sale (1 year or less in the case of an extraordinary dividend), you cannot deduct the payment in lieu of the dividend that you make to the lender. Instead, you must increase the basis of the stock used to close the short sale by that amount.

To determine how long a short sale is kept open, do not include any period during which you hold, have an option to buy, or are under a contractual obligation to buy substantially identical stock or securities.

If your payment is made for a liquidating distribution or nontaxable stock distribution, or if you buy more shares equal to a stock distribution issued on the borrowed stock during your short position, you have a capital expense. You must add the payment to the cost of the stock sold short.
Exception. If you close the short sale within 45 days, the deduction for amounts you pay in lieu of dividends will be disallowed only to the extent the payments are more than the amount that you receive as ordinary income from the lender of the stock for the use of collateral with the short sale. This exception does not apply to payments in place of extraordinary dividends.
 

Constructive Sales of Appreciated Financial Positions
You are treated as having made a constructive sale when you enter into certain transactions involving an appreciated financial position (defined later) in stock, a partnership interest, or certain debt instruments. You must recognize gain as if the position were disposed of at its fair market value on the date of the constructive sale. This gives you a new holding period for the position that begins on the date of the constructive sale. Then, when you close the transaction, you reduce your gain (or increase your loss) by the gain recognized on the constructive sale.

Constructive sale. You are treated as having made a constructive sale of an appreciated financial position if you:

1. Enter into a short sale of the same or substantially identical property,
2. Enter into an offsetting notional principal contract relating to the same or substantially identical property,
3. Enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract that provides for cash settlement), or
4. Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into a transaction described above with a view toward avoiding the constructive sale treatment. For this purpose, a related person is any related party described under Related Party Transactions, later in this chapter.

Exception for nonmarketable securities. A contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security is not a constructive sale if it settles within 1 year of the date you enter into it.

Exception for certain closed transactions. Do not treat a transaction as a constructive sale if all of the following are true.

1. You closed the transaction before the end of the 30th day after the end of your tax year.
2. You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
3. Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.

If a closed transaction is reestablished in a substantially similar position during the 60-day period beginning on the date the first transaction was closed, this exception still applies if the reestablished position is closed before the 30th day after the end of your tax year in which the first transaction was closed and, after that closing, (2) and (3) above are true.

This exception also applies to successive short sales of an entire appreciated financial position. For more information, see Revenue Ruling 2003-1 in Internal Revenue Bulletin 2003-3. This bulletin is available at www.irs.gov/pub/irs-irbs/irb03-03.pdf

Appreciated financial position. This is any interest in stock, a partnership interest, or a debt instrument (including a futures or forward contract, a short sale, or an option) if disposing of the interest would result in a gain.

Exceptions. An appreciated financial position does not include the following.
 

1. Any position from which all of the appreciation is accounted for under marked to market rules, including section 1256 contracts (described later under Section 1256 Contracts Marked to Market).
    
2. Any position in a debt instrument if:
    
   • The position unconditionally entitles the holder to receive a specified principal amount,
   • The interest payments (or other similar amounts) with respect to the position are payable at a fixed rate or a variable rate described in Regulations section 1.860G-1(a)(3), and
   • The position is not convertible, either directly or indirectly, into stock of the issuer (or any related person).
      
3. Any hedge with respect to a position described in (2).
    

Certain trust instruments treated as stock. For the constructive sale rules, an interest in an actively traded trust is treated as stock unless substantially all of the value of the property held by the trust is debt that qualifies for the exception to the definition of an appreciated financial position (explained in (2) above).

Sale of appreciated financial position. A transaction treated as a constructive sale of an appreciated financial position is not treated as a constructive sale of any other appreciated financial position, as long as you continue to hold the original position. However, if you hold another appreciated financial position and dispose of the original position before closing the transaction that resulted in the constructive sale, you are treated as if, at the same time, you constructively sold the other appreciated financial position.
 

Rev. Rul. 2002-44, Recognition of Gain or Loss For Purchase of Stock Sold Short to Close Short Sale

ISSUE
If a taxpayer enters into a short sale of stock and directs its broker to purchase the stock sold short and close out the short sale, when is a gain or a loss on the short sale realized?

FACTS

Situation 1 (losses)
In January of Year 1, Taxpayer T directs its broker to borrow 100 shares of XYZ stock and sell the 100 shares of XYZ stock in the market (the Short Sale). XYZ stock is traded on a registered securities exchange. T does not own any shares of XYZ stock. On December 31 of Year 1, when the value of XYZ stock has increased (and the value of T's short position has depreciated) T directs its broker to purchase 100 shares of XYZ stock to close the Short Sale. The purchased XYZ shares are delivered to the lender of the XYZ stock on January 4 of Year 2. The purchase of the XYZ stock on December 31 of Year 1 is a regular-way sale as described in Rev. Rul. 93-84, 1993-2 C.B. 225, with December 31 of Year 1 as the trade date and January 4 of Year 2 as the settlement date.

Situation 2 (gains)
The facts are the same as in Situation 1 except that the XYZ stock has depreciated in value and the Short Sale is closed out at a gain.

LAW
Section 1.1233-1(a)(1) of the Income Tax Regulations provides that, for income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale. Under section 1.1233-1(a)(4), if the short sale is made through a broker and the broker borrows property to make a delivery, the short sale is not deemed to be consummated until the obligation of the seller created by the short sale is finally discharged by delivery of property to the broker to replace the property borrowed by the broker.
In the context of determining holding period, Rev. Rul. 66-97 , 1966-1 C.B. 190, states that both stocks and bonds "are considered acquired or sold on the respective 'trade dates.'"
Analogously, Rev. Rul. 93-84 holds that the year of disposition for a regular-way sale of stock traded on an established securities market is the year that includes the trade date. In Rev. Rul. 93-84, the taxpayer placed a regular-way sale order on stock with his broker on December 31, 1992, but the taxpayer did not deliver the stock certificates or receive the proceeds from the sale until January 8, 1993. The revenue ruling holds that the year of disposition and realization is 1992.
Section 1259(a)(1) provides that if there is a constructive sale of an appreciated financial position, the taxpayer shall recognize gain as if such position were sold, assigned, or otherwise terminated at its fair market value on the date of such constructive sale. The term "appreciated financial position" is defined in section 1259(b)(1) to include any position with respect to stock if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. The term ``position'' is defined in section 1259(b)(3) to include a short sale. Pursuant to section 1259(c)(1)(D), in the case of an appreciated financial position that is a short sale, a taxpayer is treated as having made a constructive sale of the appreciated financial position if the taxpayer acquires the same or substantially identical property.

ANALYSIS

Situation 1 (losses)
Pursuant to section 1.1233-1(a)(1), the Short Sale is not consummated until the XYZ stock is delivered to close the Short Sale. Although T is treated as having acquired the XYZ stock on the trade date (see Rev. Rul. 66-97; see also Rev. Rul. 93-84), the XYZ stock will not be delivered to close the Short Sale until January 4 of Year 2. Therefore, T does not realize the loss on the Short Sale until January 4 of Year 2.

Situation 2 (gains)
As in Situation 1, T is treated as having acquired the XYZ stock on the trade date, December 31 of Year 1. See Rev. Rul. 66-97; see also Rev. Rul. 93-84. At that time, unlike in Situation 1, the price of XYZ stock has decreased. Therefore, the value of T's Short Sale has increased, and T holds an appreciated financial position within the meaning of section 1259(b)(1), that is, the short position. Section 1259(b)(3). Section 1259(c)(1)(D) provides that if a taxpayer holds an appreciated financial position that is a short sale, the acquisition of the same or substantially identical stock is a constructive sale transaction. Therefore, T has entered into a constructive sale transaction by acquiring the same or substantially identical stock as the stock underlying the Short Sale. Pursuant to section 1259(a)(1), T realizes gain on the Short Sale on December 31 of Year 1.

HOLDING

1. In Situation 1 (losses), T realizes the loss on the Short Sale on January 4 of Year 2, the date the Short Sale is closed by delivery of the stock.
    
2. In Situation 2 (gains), T has constructively sold the Short Sale on December 31 of Year 1. T realizes gain in Year 1 as if T had sold, assigned, or otherwise terminated the Short Sale at its fair market value on December 31 of Year 1.
    

DRAFTING INFORMATION
The principal author of this revenue ruling is Kate Sleeth of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Ms. Sleeth at (202) 622-3920 (not a toll-free call).
 

Article: Short Sellers Face Unfavorable Tax Situation
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