Short Sale Taxes

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What Is a Short Sale?

A short sale is where a seller sells an item that he does not own and then buys and delivers the item at a later time. Basically, the seller is betting that the item will go down in price in the future, so that he/she can buy the item at a cheaper price than it was sold. When the seller actually delivers the item to the buyer, this is called "closing" the short sale. 

When Is a Short Sale Taxed?

When a seller makes a gain by buying the item he sold short at a lower price that it was sold, the seller will have to recognize income. Generally, the seller will not be taxed until the short sale is "closed." There are two situations where a short sale is considered closed: 

     1. Delivery of the property that was sold short; or 
     2. The property that was sold short has now become substantially worthless. 

Can I Use the Loss From a Short Sale To Offset My Income?

Like gains from a short sale, losses from a short sale are not recognized until the short sale closes. If the property that the seller uses to close the short sale is a capital property, then the resulting loss will be a capital loss and be subject to the capital gains tax rules

Wash sales rules may also apply to disallow the loss from a short sale. When the seller sells short at a loss, if he/she sells substantially identical stocks or enters into another short sale of substantially identical stocks within 30 days before and after the original short sale, then any result loss will be disallowed. 

How do I Determine the Holding Period For My Short Sale Transaction? 

Generally, the long-term/short-term character of the short sale transaction is determined by the holding period of the property used to close the short sale.  For example: T enters into a short sale on May 5th of 20 shares of ABC Inc. T does not own any ABC Inc. at the time. On August 20th, T buys 20 shares of ABC Inc. and delivers them to the buyer, thereby closing the short sale. Since T has only held the stock for less than one year, the short sale is a short-term transaction. 

Special rules apply if the seller actually owns substantially identical property to the one sold short at the time of the short sale. 

What is Short Sale Against The Box? 

Short sale against the box is when the seller short sells an item that he already owns at the time of the short sale. Before the creation of the constructive sales rules, a taxpayer was able to lock in the appreciation from the items he/she owned by short selling them and was able to defer the gain until he/she closed the short sale. 

What is a Constructive Sale? 

A constructive sale normally occurs when the seller short sells an appreciated item that he/she owns at the time of the short sale and does not close the short sale before the close of the tax year. However, constructive sale may also occur when the seller enters into certain hedging transactions. 

If the taxpayer engages into a constructive sale, then he/she will have to recognize the gain from the appreciated item as if it were sold at for its fair market value at the date of the constructive sale. 

A safe harbor rule is available to avoid this constructive sale treatment for certain short sale transactions closed within 30 days after the close of the tax year. 

Do I Need an Attorney to Help Me With My Tax Problems? 

Tax laws are complex and ever-changing. Although there are various tax preparation softwares on the market that may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable tax attorney can. If you are unsure about the characterization of your expenses or you need someone to represent you before the IRS, a tax attorney can help you.  

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Last Modified: 11-28-2011 04:32 PM PST

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