Most of the time, we buy stocks because we believe that the companies behind them will continue to grow and improve, boosting their share prices -- and making us richer. In the market, it's known as "going long." But when you "short" a stock, you're betting that the company will perform poorly, driving down its share price. If you decide to short the stock, you should keep in mind some rather counterintuitive tax issues.

How it works
"Buy low, sell high" is the traditional mantra of stock investing. When you short a stock, you do exactly that -- but in reverse. You sell shares when the stock is high, then buy them back at a lower price after it falls. 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 that you sell. Somebody else (usually your broker) lends you the shares, and you promise to "repay" those shares at some future time. You sell the shares right away, pocketing the proceeds, then wait for the stock to fall. When it's time to repay the shares you borrowed, you buy an identical amount of shares on the market -- hopefully at a lower price -- and immediately turn them over to your broker or whoever else lent them to you. If the stock lost value during this time, you made money from the difference between the initial sale and subsequent purchase prices. But if the stock price increased, you lost money.

There's another way to settle your debt for the shares you've borrowed: You can deliver stock that you already owned prior to entering into the short sale, provided the shares come from the same company you shorted. But if you enter into a short sale on a stock in which you already have a long position -- referred to as "shorting against the box" -- you could run afoul of the constructive sale rules You'll want to read more about these rules before you enter into any type of short sale "hedge" transaction with stock that you own.

To keep things relatively simple, from here on out we'll assume that all of the short sales will be "true" shorts, exempt from the constructive sale rules.

For example...
In January 2005, you borrow 100 shares of Company X from your broker. You promptly sell those shares for $50 a stub, receiving $5,000 for the sale. In March 2006, you see that the stock price has declined to $15 a share. You decide to purchase 100 shares of Company X for a total price of $1,500, and return those shares to your broker, settling your debt. Your resulting profit: $3,500.

But what happens if your research was faulty, shares of Company X increase to $65 apiece, and you don't see a downturn in sight? You'll likely decide to cut your losses and buy back the 100 shares you owe, at a humbling cost of $6,500. You then return those shares to your broker and head off to lick your wounds, $1,500 poorer.

Tax issues
Is the gain or loss recognized on your short sale 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. Think again.

In order for any gain to be long term, you must hold and own the shares in question for more than one year. In this case, shares you used to make the original sale were borrowed from someone else. You owned nothing until you actually purchased the shares needed to settle your debt. So the shares that you actually purchased were in your hands for a very short period of time -- much less time than allowed by law to recognize a long-term gain or loss.

In any simple short sale, any gain or loss will be considered short-term, regardless of how long the short position may have been open.

Related issues
For tax purposes, the sale portion of your adventure in shorting is just like any other stock sale -- your broker will even issue a Form 1099B to commemorate the occasion. Don't panic! Even if your short position is open at the end of the year, you'll want to report the sale portion of the short sale in the year that 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 also 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.

What happens if you short a stock that pays dividends? The person from whom you borrowed the stock will want his or her dividend payments, and will look to you for those payments. When you make the payments, how do you treat them for tax purposes? They could be an investment interest expense, or an adjustment to the basis of the shares used to close the short sale. To understand when to apply the rules correctly, read more about dividends paid on short sales.

And what if you were the one who loaned the stock? How do you treat your dividends? You might not think that you ever loan your stock out to short sellers, but that's not always the case. Generally, your broker agreement will allow the broker to "loan" your shares to short sellers ... many times without your permission. Be aware -- the dividends paid on shares loaned out are not available for the lower tax rate on qualified dividends.

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. However, he'll be glad to help you compute your gain or loss when you finally sell a stock.