In stock parlance, betting that a company's share price will rise over time is known as "going long." However, if you find a disastrously run company headed for near-certain financial doom, you can also bet that its stock price will decline -- known as "selling short." Before you unleash your shorts, though, you'll need to remember some rather counterintuitive tax rules.
How shorting works
In order to short a stock, you generally have to sell shares you don't actually own. This concept may seem strange to you, but it's not as tricky as it sounds.
First, you borrow a block of shares from someone else -- usually your broker -- with a promise to "repay" those shares at some later date. You immediately sell all those shares at their current, presumably inflated price, and wait for the stock price to fall. If it does, you can buy back the shares at a lower price, return them to whomever lent them to you, and pocket the difference in selling and buying prices as a handy profit.
This is the usual way that investors short stocks, but it's not the only one. You can actually short a stock you already own. This is called "shorting against the box," and it's got some associated 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. For this article, we'll assume that all short sales are the sort of "true" shorts we initially described.
Shorting in action
Suppose that 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 also have to repay those 100 shares to your broker at some future time. On March 25 of the following year, you see that the stock price has declined to $15. You decide to buy back 100 shares of Company X for $1,500, then return those shares to your broker, fulfilling your obligation. Since you sold for $5,000 and bought for $1,500, you made $3,500 in profits.
But what if your research was wrong, 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. Give those shares to the broker, and you're done, except for licking your wounds. Since your sales price was $5,000, and your purchase price was $6,500, you're now $1,500 in the hole. Ouch.
Tax issues
Now that you've completed your short sale, is your gain (or loss) short-term or long-term? The transaction was open for more than a year, so you might think that "long-term" is the answer. Think again.
In any long-term gain or loss, 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. You owned nothing until the moment you actually purchased the shares, and you only bought them to repay the ones you'd borrowed. The shares you purchased were only in your hands for a very short time.
Other reporting issues
When you initially sell the shares you borrowed, it's a real, live sale. Your broker will even send you a Form 1099B to commemorate the occasion. 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).
However, 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 transaction as an open short sale, with no gain or loss. The instructions for Schedule D will give you the details you'll need to report this.
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 that very subject.
When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. 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.
