Selling Short Against The Box
[BRIEFING.COM - Robert V. Green] For years, the selling short against the box technique allowed you to lock-in capital gains you currently have, but report them in the subsequent year. It was a frequent practice in December. The rules are different now, but there are still ways to make this work.
Selling Short Against The Box
The technique used to be simple.
Situation: for a position on which you have capital gains and you want to lock in gains now, but pay taxes on it next year.
Sell short an equivalent number of shares of the stock in your position. This provides cash at the current value of the stock - in effect, giving you the full monetary value of the current stock position.
Keep the short position until January.
Close the short position by turning in the long position shares to return the borrowed short shares. The long position was closed on the day the shares were delivered, effectively shifting the capital gains date into the subsequent year.
This technique was eliminated in 1997 with the introduction of "constructive sale" rules. These rules deemed that in the above situation, the sale of the long position is "deemed" to have occurred on the day the short position was opened.
The Tax Rules To Prevent Shorting Against The Box
In 1997, the tax rules for shorting against the box were strengthened. The primary objective of the rules, however, were to prevent unlimited lock-in of gains. The estate of Estee Lauder, the cosmetic queen, used shorting against the box to secure high values of the stock until her death in 1995. At that time, the short position was closed, and the capital gains were realized, but because the basis of the stock was in an estate, the sale produced no capital gains. The $150 million transfer of wealth without capital gains through the use of this technique prompted Congress to write rules against it.
The use of the shorting against the box technique to postpone tax reconciliation forever has been effectively eliminated.
Short Term Use Still Possible
However, for locking in profits now, and a possible short-term postponing of taxable profits until the subsequent tax year, there are ways to use the shorting against the box technique.
To avoid the constructive sale rules, you need to follow all three of these conditions.
You close the short transaction before January 30 (30 days before the start of the new tax year).
You hold the appreciated transaction for 60 days after the close of the short position.
You had no other offsetting short sales. (you can't dodge the rules by setting up multiple short positions.)
IRS Publication 550 contains the full definition for these rules.
How To Use Shorting Against The Box Today
Shorting against the box today is still possible, but it involves some risk.
If you want to avoid risk entirely, and lock in all of your gains on a stock, sell now and pay taxes in this year. If you want to lock in your profits and take a chance at postponing the tax date, you can use the short sale against the box technique.
Here are the steps to use this technique today.
Assume you have 1,000 shares of XYZ worth $20 with a cost basis of $5 on a long-term basis. You want to lock in your gain of $15,000 but pay the tax next year.
First, sell short an equivalent number of shares as your long position. In this example, $20,000 would be entered into your margin account from the short sale. (Cash proceeds from a short sale are not accessible, generally, until the position is closed - but the cash is there.)
Now, between now and January 30, you have a zero-sum position on the stock. Any gain in XYZ is offset by a loss in your short position. Any decline in XYZ shares is offset by a gain in your short position.
Close the short position before January 30 (the 30th day of the new tax year). Any gain or loss on this position is a short-term capital gain.
If you now hold the original XYZ long position shares more than 60 days after you close the short position, the sale of XYZ is the date of the sale of the stock and you can report the sale as of that date.
If you sell the original XYZ long position shares before 60 days have elapsed (from the close of the short position), the date of the sale is "deemed to be" the date you originally opened the short position (which is the prior tax year).
Therefore, you must make a decision on the day you close the short position: what direction is the stock headed?
If you feel the stock will decline from that point further, then sell the original long stock on the same day. You will report the sale "as-if" it occurred on the day you first opened the short position. The "constructive sale" rules of the IRS will apply to this sale.
If, however, you feel that the stock is headed upward at that time, you may want to hold the long stock position. If you hold this original position for more than 60 days from the time you close the short position, then the two transactions are deemed to be unrelated and you can report the sale of the long-term position in XYZ in the tax year in which it occurs.
Note that from the time you open the short term position in December to the time you close the short position in January, any stock movement since that opening day has a net-neutral impact on your position. However, any gains on your short position will be taxed at short-term rates; if your original position was a long term taxable gain, you have effectively shifted some of those gains to short-term status.
The timing of this sequence looks like this:
Time Action Result
December You sell short an equal number of shares of the position you want to protect. From this point on, movement in the stock is neutral to your position, although a decline in the stock will shift some long term gains to short term status.
Before January 30 Close the short position. Any gains from the short sale are short-term gains. Losses are actually preferred as they could be used against other short-term losses, if the original stock never falls.
At Time of Closing Short Position Make decision. If you feel that the stock will decline from here on, sell the original long position. The taxable gain must be recorded
If you feel that the original long position stock will rise from this point, hold the stock. If you are able to hold for 60 days, the gain will be recorded on the date of the actual sale.
Before 60 days are over Do not open any offsetting transaction. Any additional offsetting transaction, such as another short sale, resets the 60 day clock.
Before 60 days are over Set stop loss order If you decide to hold the long position after closing the short position, in hopes of further gains, you should make a decision as to much risk you take. You can set a stop loss order at that level. If it is invoked, you will book the sale as if it occurred the tax you opened the short position.
Note that if you open any "offsetting" transaction against the original long position, such as selling put options or opening an additional short position, before the 60 day "naked holding" period ends, you must hold the long position for an additional 60 day period after the new short position is opened.
The range of possibilities for using the short sale against the box technique look like this, assuming that you make a short sale in December, with the intent of protecting against a decline in January or February and selling the stock in March or April, whenever 61 days after the short position is closed.
Time Stock Rises Stock Falls
December - open short position no net effect no net effect
January - close short before January 30 loss on short position gain on short position
February - sell long position gain on long position is taxed as if it occurred in December gain/loss on long position is taxed as if it occurred in December
March-April (60 days after close of short position) gain on long position is taxed on actual day of sale gain/loss on long position is taxed on actual day of sale
Note that you can win both ways if the following happens: the stock declines in December and January, giving you a gain on the short position, but then rises for 60+ days after the close of the short position. In this scenario, you get the insurance of locked-in-gains you wanted, plus you get to postpone the tax until the subsequent year.
The middle ground is you get the locked-in gains you wanted, but you wind up having to book then in this tax year.
Losing both ways occurs if the stock rises during December and January, then falls through February-April. In this scenario, you lose on the short position when you close it in January, then lose again when the stock falls in March and April. To minimize the risk in this scenario, you can set stop loss orders after closing the short position at a price level with which you are comfortable.
Summary
What this all boils down to is this: if you want to take a shot at postponing capital gains until next year, you can use the shorting against the box technique to take a chance at it.
At a minimum you can lock in the gains you want until at least January 29, with only the risk of shifting some gains from long-term status to short term status. At best, you can lock in the gains through January, have a gain on the short position, and then have additional gains on the stock from February to April and postpone the tax recognition date.
In any scenario, when you are thinking about selling now to capture a gain, you can at least postpone the decision until near the end of January as to when you want to recognize the gain. If at the end of January, you think that the stock could continue to rise, you may want to go for an additional 60 day holding period. If not, you can close both positions - and have effectively the same results as if you sold outright now.
Consultation with your tax attorney is recommended if you decide to go this route. Things get more complicated quickly, particularly if you are subject to the alternative minimum tax or have other tax considerations.
Of course, all of this depends on your having capital gains which puts you ahead of most people anyway.
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