First, let’s describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company.
When an investor or a trader goes short, he or she is anticipating a decrease in share price.
A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of sale in two steps.
- You sell short. You borrow property and deliver it to a buyer.
- 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 you held at the time of the sale. Delivery of property borrowed from another lender does not satisfy this requirement.
Now, let’s look at a couple scenarios: Suppose you sold Short Stock ABC and the stock became worthless before you covered your short. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.
Another scenario involves what the IRS calls a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. Here is an example to make it easier to understand.
On May 8, 2016, you bought 100 shares of ABC Corporation stock for $1,000. On September 10, 2016, you sold short 100 shares of similar ABC stock for $1,600. You made no other transactions involving ABC stock for the rest of 2016 and the first 30 days of 2017.
Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your ABC 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 and your new holding period in the ABC stock begins on September 10.
As you may know, the IRS defines two types of capital gain. If you hold a position for more than a year it’s long term capital gain taxed for most Americans at 15%, and if you hold a position for a year or less it’s short term capital gain taxed at your ordinary income tax rate.
Generally, 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.
Therefore, in most cases the short sale will be considered a short-term capital gain transaction.
Here is an example: Even though you do not own any stock of XYZ 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 XYZ 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 1 day.
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 to property 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.
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.
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.
As You can see selling short has many rules, regulations and elections. Your job is to focus on successful trades and our job is to offer you the tax strategies and recommendations that will minimize your tax liability and keep you in compliance.
Happy New Year!