If you find a quality company that impresses you with its management, history, products, and background, you'll likely bet that the stock price will increase over time. In stock parlance, that's called "going long" on the stock.
But what happens if you find a company with crummy products, accounting irregularities, and a management team under indictment? Well, it's possible that you'll bet that the stock price will decline over time (assuming it hasn't hit bottom already). In that case, you might want to take a "short" position on that stock. By shorting a stock, you're betting that the share price will decline. And there are some rather counterintuitive tax rules that you'll need to know.
How it works
Basically, you sell the stock now, when the share price is high, and then purchase the stock at some time in the future when the share price has declined. So what you've really done is bought low and sold high, but in reverse. If you've never made a short sale, the concept might seem strange to you. How can you sell something that you don't own?
You can't. Which is why you borrow the shares from somebody else (usually your broker) and promise to "repay" those shares of stock at some time in the future. How will you make that repayment? When you actually purchase the shares in the future, you'll then immediately turn those shares over to your broker (or whomever else you borrowed them from), and your loan is repaid. Your position is then closed. If the stock declined in value during this time, you made money. If the stock price increased, you lost money.
This is the usual way investors short stocks, but not the only way. You can actually short a stock you already own. This is called "shorting against the box," and there are some rules that could bite you in the behind. Read about these constructive sale rules before you enter into any type of short-sale hedge transaction with stock you own.
However, for this article, we'll assume that all of the short sales will be true short sales, and none of them will encompass sales that short against the box.
On Jan. 10, you borrow 100 shares of Company X from your broker. You then sell those shares for $50 a stub. You'll receive $5,000 for the sale, but you'll have a debt to your broker and will have to repay those 100 shares to your broker at some time in the future. On March 25 of the following year, you see that the stock price has declined to $15. You decide to purchase 100 shares of Company X shares at a cost to you of $1,500. You then give those shares to your broker, and your obligation is fulfilled. You profited to the tune of $3,500 (you purchased the stock for $1,500 and you sold it for $5,000).
But what happens if your research was faulty, and Company X shares increase to $65 with no downturn in sight? You may decide to purchase those 100 shares and close out the position. It'll cost you $6,500 to make the purchase. You'll then give those shares to the broker and you're done, except for licking your wounds. You'll find that your purchase price was $6,500, your sales price was $5,000, and your loss on the transaction was $1,500. Ouch.
So you've completed your short sale. Is the gain or loss that you recognized short term or long term? Since the transaction was open for more than a year, you might think that your gain would be long term. But you'd be wrong.
For any gain or loss to be long term, you must hold and own the shares in question for more than one year. In this case, you owned the shares for just a few minutes or even seconds. The shares that you used to make the original sale were borrowed and you didn't own them at all. You owned nothing until the time that you actually purchased the shares. And you only purchased those shares to repay the shares that you borrowed. So the shares that you purchased were in your hands for a very short time.
Other reporting issues
When you make the sale portion of your short sale, it's a real, live sale. And your broker will issue a Form 1099B to you indicating that the stock was sold. Don't panic! Even if your short position is open at the end of the year, report the sale in the year it was made. That will allow you to reconcile your Schedule D transactions with the Form 1099B that you receive from your broker (which is exactly what the IRS computers will do).
But if your position is still open at the end of the year, you'll have no tax liability on the short sale. You simply report the sale as such, with no gain or loss, and report the transaction as an open short sale. The instructions for Schedule D will give you the details you'll need to report such a transaction.
Additionally, what happens if you short a stock that pays dividends? The person from whom you borrowed the stock will want their dividend payments. When you make the payments, how do you treat them for tax purposes? They could be an investment interest expense, or they could be an adjustment to the basis of the shares that you use to close the short sale. To understand when and how to apply the dividend rules correctly, take a look at my article on this very subject.
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.