Image source: Flickr user Rafael Matsunaga.

Most investors are content to own stocks in their portfolios, betting on the long-term trend of the rising stock market to help their positions become profitable. However, those rare investors who take on the potentially unlimited risk of selling a stock short can make money even in a down market. That extra chance of reward comes at a price, though: As the borrower of a stock, you have the obligation to reimburse whoever you borrowed your short-sold shares from for any dividends the stock paid while you had your short position. Moreover, accounting for dividends paid on short sales can be a major hassle.

Let's take a look at how dividends paid on short sales work and how you have to deal with them in your records and on your tax return.

Why short-sellers see cash disappear from their brokerage accounts

First, it's important to understand why you have to pay dividends on short sales. When you decide to sell a stock short, you need to obtain shares from a shareholder who's willing to lend them to you. That lender is willing to lend shares so long as two things happen: 1) you return the shares and 2) you make the lender whole for any corporate event that occurred while you borrowed the shares. The most common such corporate event is a dividend, in which case the lender wants to get the same amount of money he or she would get if you had never borrowed the shares.

Of course, investors rarely know their counterparties in the modern investing world. All you'll see is that when the stock you've sold short pays a dividend, your broker will take cash out of your account and pay it to the investor who loaned you the stock. That transaction is known as a payment in lieu of dividend, and it can add a great deal of complexity to your tax return.

45 days makes all the difference

Ordinarily, if you receive a dividend, it's treated as investment income. It's therefore only natural to think that paying a dividend on a short sale would be treated as an investment expense. Yet the real answer is more complicated and involves holding periods on your short position.

Source: Phillip Ingham via Flickr.

So long as you keep your short position open for longer than 45 days, then you're allowed to deduct payments in lieu of dividends on short sales as investment interest. That's an itemized deduction and is thus only available if you don't take the standard deduction.

If you close your short position within 45 days or less, though, you're not allowed to deduct those payments as itemized deductions. Instead, you have to treat them as part of the total price you paid to buy the shares to close the position, so the payment becomes part of the capital gain or loss you realize on your short sale.

Note that there's a special IRS rule to deal with special dividends. If a dividend is greater than 10% of the price of a share of common stock or 5% of a preferred stock, then the required holding period becomes a year, rather than 45 days. Therefore you'd have to have your short position open for a year and a day to be able to deduct the payment.

Finally, there are some rules that effectively push the pause button on the holding period. If you own a call option to buy the stock or have any other offsetting position that the IRS treats as hedging your short sale, then it temporarily stops the clock on the short-sale holding period for these purposes.

Most investors who sell stocks short focus on the risk involved in betting against the stock. Yet being aware up front whether a given stock pays a dividend could help you prepare for the additional burdens involved with dividends paid on short sales.