A short sale occurs when a seller sells an item that he does not currently 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 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 than it was sold to the buyer, the seller will have to recognize the income made from the transaction. Therefore, the seller will not be taxed until the short sale is "closed". There are two situations where a short sale is considered closed:
Delivery of the property that was sold short; or
The property that was sold short has now become substantially worthless.
Can I Offset My Income with a Short Sale Loss?
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 a seller from using the loss from a short sale to offset their taxable income. 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 that loss will be disallowed.
How Do I Determine the Holding Period?
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 sells 20 shares of ABC Inc. via a short sale on May 5th. 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 holding period rules apply if the seller already owns property that is substantially identical to the property 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 owned by short selling them and was able to defer the gain until he closed the short sale.
What Is a Constructive Sale?
A constructive sale normally occurs when the seller short sells an appreciated item that he 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 is required to recognize the gain from the appreciated item as if it were sold for fair market value at the date of the constructive sale.
However, a safe harbor rule is available to avoid this constructive sale treatment for certain short sale transactions closed within 30 days after the end of the tax year.
Can a Lawyer Assist Me with My Tax Issues?
The laws governing short sales and taxes are very complex. If you have any issues with determining the taxes that should be levied on your short sale, a tax lawyer will be able to help you resolve those issues. Also, a tax lawyer will be able to represent you if you end up having any trouble with the IRS due to short sale tax problems.