A short sale occurs when a seller sells an asset or other item that they do not currently own at the time of the short sale and then purchases and delivers the asset at a later date. In sum, the seller is basically betting that the price of the asset will depreciate over time or in the future. This happens so that eventually they can buy the asset again at a later time and at a less expensive price than what it was when they initially sold it.
When a seller finally delivers the asset or item to the buyer, this process is known as “closing” the short sale. Although short sales usually refer to situations that involve different types of securities, this process also exists in a real estate context, such as when an individual short sells a house.
However, short selling a house is very different from short selling a security. Thus, it may be in your best interest to speak to a local tax lawyer for further advice regarding short sales and taxes if you are unsure of whether you owe money on a short sale or are facing some other similar short sale issue.
For the purposes of this particular article though, it is important to note the remainder of the discussion will focus on short sales in relation to investment vehicles like stocks and other assets or securities. For example, the phrase “shorting a stock” is a type of short sale transaction. Essentially, an investor will sell a stock that they do not own by purchasing it from a broker-dealer in order to make a profit.
In reality, the investor is actually borrowing it from the broker-dealer and ideally selling it for a higher price than the amount for which they bought it. The investor does this because they are banking on the stock falling below the initial purchase price. Eventually, the investor will be obligated to buy back the stock that they sold (again, ideally at a lower price) and to return it to the broker-dealer who originally lent it to them.
When Is a Short Sale Taxed?
In general, a short sale is taxed when a seller makes a profit off buying an asset that they sold “short” (i.e., at a lower price) than the price of the asset when it was sold to a buyer. In such a scenario, the seller will be required to report the income from this type of short sale transaction. However, the seller will usually not be taxed on the gain they earned until the short sale is considered to be officially closed.
For example, there are two primary circumstances in which a short sale will be viewed as closed under the law. These two circumstances include when:
- The property that is sold short gets delivered to its buyer; or
- The property that was sold short in the sale has now depreciated or become substantially worthless.
Can I Offset My Income with a Short Sale Loss?
Similar to gains from a short sale, a loss from a short sale is not recognized until the short sale transaction is officially closed. If the assets or securities that a seller uses to close a short sale, which is known as a capital asset, then the resulting loss on the sale would be considered a capital gains loss and therefore would be subject to the capital gains tax rules set out in Section 1259 of the U.S. Tax Code.
In addition, wash sales rules may also apply to prevent a seller from using a capital gains loss from a short sale to counterbalance or offset the seller’s taxable income. When a seller sells short at a loss, if the seller sells substantially identical securities (e.g., stocks), then they will not be able to claim this loss to offset their income taxes under this rule.
How Do I Determine the Holding Period?
In general, the long-term and short-term characteristics of a short sale transaction are determined by the holding period of the property used to officially close the short sale. For instance, imagine that a taxpayer sells twenty shares of a company during a short sale in July and does not own any other shares of that company at the time of the short sale.
Next, imagine that this taxpayer purchases twenty shares of the company they previously sold in October and delivers them to the actual buyer, which would officially close the short sale transaction. Since the taxpayer only owned the stock for a few months or less than a year, this transaction would qualify as a short-term, short sale transaction.
In addition, special holding rules may apply if a seller already owns property that is substantially identical or similar to the type of property that is sold at the time of the short sale. For example, if a taxpayer owns several of the same types of securities or assets, but only sells some of them.
What Is Short Sale Against the Box?
A short sale against the box is when a seller short sells an asset that they already own at the time of the short sale. This is the kind of transaction that existed before the constructive sales rule was put into place. For example, prior to the creation of the constructive sales rule, taxpayers had the ability to lock in the appreciation value of assets they owned by short selling them.
In addition, a short sale against the box transaction also allowed a taxpayer to defer reporting any capital gains taxes associated with the short sale until they officially closed the short sale.
What Is a Constructive Sale?
A constructive sale refers to when a seller short sells an appreciated asset that they own at the time of the short sale while also owning long positions or significantly similar assets, and does not close the short sale before the end of the current tax year. Thus, if a seller participates in a constructive sale, then they must report the gain from the appreciated asset as if it were sold at fair market value on the date of the constructive sale.
It should be noted that there is a safe harbor rule that may apply to avoid having to report capital gains related to a constructive sale for certain types of short sale transactions that are closed within thirty days after the tax year has ended.
Can a Lawyer Assist Me with My Tax Issues?
The laws that govern short sales and taxes are very difficult to understand without legal expertise. Therefore, if you are experiencing tax issues that are associated with a short sale, then you should consider contacting a local tax lawyer immediately for further guidance on those issues.
A lawyer who is qualified to handle short sale tax matters will be able to answer any questions or concerns regarding such issues and can recommend the best way for you to resolve them based on your circumstances. Your lawyer will also be able to provide legal representation should you encounter any other issues with the IRS regarding short sale tax problems and need to appear before an administrative panel or in court.