With the market as it, many of you have decided to include shorting in your investment strategy. It's quite possible that one of the companies that you shorted was one that pays a cash dividend. Since you are likely borrowing the shares that you initially sold to create your short position, you are required to reimburse the lender of the stock for the dividends that he missed. Your broker probably notified you of that fact, and reduced your cash position in your account by the amount of the dividend.

The question then becomes: Where and how do you report this payment on your tax return? Is it an adjustment to the basis of the stock in the short sale? Or is it a period expense that can be deducted immediately, even if the short position was not closed in the tax year you're filing. As with much of the tax law, there is no clear-cut answer.

Jar of coins labeled "dividends"

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The rule
If you borrow stock to make a short sale, you might have to remit payments to the lender 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 and you itemize your deductions.

If you close the short sale by the 45th day after the date of the short sale, you can't deduct the payment made to the lender in lieu of the dividend. Instead, you must increase the cost basis of the stock used to close the short sale by that amount.

To determine how long a short sale is kept open, don't 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. In addition, don't include any period during which you are considered to have diminished your risk of loss from the short sale by reason of holding one or more other positions in substantially similar or related properties.

To deduct these expenses, they are treated as investment interest expenses, and are subject to all of the rules and regulations involving investment interest expense. Report these expenses on Schedule A of your tax return. If you don't itemize your deductions (i.e., you claim the standard deduction) investment interest expense won't be tax-effective for you, and you'll miss this deduction. And if you can't take the deduction because you don't itemize your deductions, it's lost forever. There are no "elections" that you can make in order to use the investment interest deduction to reduce any gain (or increase the loss) when you eventually close your short position.

An example
Let's say you short 100 shares of XYZ Company on Feb. 1 at $10 a share. On Feb. 15, your broker notifies you that your account will be reduced by $50 for the dividend paid by XYZ Company to its shareholders. On March 10, you close your short position by buying 100 shares of XYZ at $8 a share. Since the short position was not open for at least 46 days, you cannot use the $50 in-lieu-of-dividend payment as a current expense. Rather, this $50 is added to the price of the stock that you purchased to close the position. In the example above, your net gain on your short position would be $150 ($1,000-($800+$50)=$150).

Let's use the same example, but change the dates. Let's say that you don't close the short position until May 15. In this case, the in-lieu payment of $50 would be treated as investment interest, which is deductible on Schedule A (assuming that you itemize your deductions), and your gain on the closing of the short position would be $200.

Now, this might not make much difference during the year, but at year-end, it might make the difference between a current-period deduction and an adjustment to basis. So now is the time to review your short positions and see if any will pay a dividend.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.