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< MONEY >
January 8, 1999
Short Sales/Constructive Sale Rules
By Roy Lewis (TMF Taxes)
I have received a number of questions about "shorting against the box" recently. The "short against the box" strategy used to be very much in favor. It allowed you to "lock in" your gains, but hold off on actually making the sale and reporting the gain until some time in the future. Here is how it worked:
Example: Jill bought 100 shares of ABC many months ago for $15 per share. In December 1998, the value of ABC shares exploded to $75 per share. Jill wanted to lock in her gain of $60 per share, but did not want to actually sell the stock until some time in 1999.
So Jill borrowed 100 shares of ABC from her broker, sold them (a short sale against the box), and used those shares to "hedge" her original investment. If the stock goes up, her "long" shares make money, while her "short" sale loses a corresponding amount. If the stock goes down, the same happens in reverse. In any event, there is no way that Jill can lose any of her $60 per share gain because of the "short against the box" position� no matter where the stock may go -- up or down. And Jill could keep that offsetting position open for as long as she wanted without any tax issues or reporting.
But no longer. Unless Jill meets certain exceptions and makes certain moves by specified times, she will fall under the new constructive sale rules, and Uncle Sammy will deem that she really SOLD her stock in 1998, and tax her accordingly for tax year 1998. Here is the way it works�
Pursuant to changes made by the Taxpayer's Relief Act of 1997, taxpayers must recognize gains (but not losses) on constructive sales of any appreciated financial position in stock, a partnership interest, or certain debt instruments. A constructive sale occurs when the taxpayer enters into one of the following transactions with respect to the same or substantially identical property:
1. A short sale
2. An offsetting notional principal contract
3. A futures or forward contact
Oops. So, whether she knew it or not, Jill violated the constructive sale rules because she made a short sale against her original "appreciated financial position." Unless she makes some moves in the near future, Jill will be deemed to have SOLD her 100 shares of ABC in 1998, and will be expected to report that sale in 1998 and pay the associated taxes on her 1998 tax return. Ouch. This could really screw up her tax planning.
What moves could she make? She may be able to meet the exception to the constructive sale rules if she acts fast. Here are the requirements to qualify for the exception to the constructive sale rules.
The law says that any transaction which would otherwise be treated as a constructive sale can be disregarded (i.e., the constructive sale rules will NOT apply, and the sale will NOT be recognized in 1998) if:
1. The transaction is closed before the end of the 30th day after the close of the taxable year; and
2. The taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date such transaction is closed; and
3. At no time during that 60-day period is the taxpayer's risk of loss with respect to such position reduced by reason of a circumstance relating to a diminished risk of loss if references to stock included references to such position.
So what does this really mean? It means that in order for Jill to dodge the constructive sale rules, she will have to do the following:
1. Close her short sale position no later than January 30, 1999. Since Jill's "taxable year" ends on December 31, she has until January 30 of the following year to close her short sale position as noted in item #1 above; and
2. Hold her "long" position for at least 60 days after the date of the close of her "short" position as noted in item #2 above; and
3. Don't do anything to "hedge" her "long" position again during that 60-day period after the close of her "short" position.
Example: So let's say Jill suddenly realizes that she will be in violation of the constructive sale provisions. She does NOT want to be forced to recognize the gain on her sale in 1998 under the constructive sale provisions, so she takes the following steps:
Jill closes out her "short sale" position on January 20, 1999. That is well within the 30 days allowed by the law. So she has met the first requirement.
Then, she continues to hold her "long" position until March 26, 1999, at which time she sells her "long" position and realizes her gain in tax year 1999. Since she held the "long" position open for at least 60 days after the closing of the offsetting "short" position, she has met the second requirement.
Finally, during the 60 days that the "long" position was held open, Jill didn't do anything (in the form or short sales, options, etc.) to "hedge" her position. That meets the third requirement and qualifies Jill for the exception to the constructive sale rules. Jill can report both the "short" and "long" sales in the 1999 tax year.
Risks of Using the Exception
After going through this process, could Jill again "short" this position and effectively hedge it? Sure. But she would have to go through the process all over again. She would have to close out her short position again in January 2000, and would have to hold her "long" position open at least 60 days after the closing of the short position. By doing that, it is possible for Jill to hedge her transaction for many months (or even many years) in the future.
So if that's all there is to it, why wouldn't everyone simply follow the "exception" rules to avoid the constructive sale? Basically because of the requirement to hold the "long" position open for at least 60 days. As many of you know, much can happen to the price of a certain stock in a 60-day period. Jill may decide that she doesn't want her "long" position open (and virtually naked) for this 60-day period.
If the stock price tumbles during that 60-day period, Jill could lose REAL dollars� possibly many more dollars than she would lose in taxes if she simply reported the sale in 1998. Uncle Sammy requires you to take that risk in order to maintain your "short against the box" position and push your gain into a future year. If you are willing to take the risk, Uncle Sammy is willing to let you move your gain into another year. If you are not willing, Uncle Sammy will also not be willing.
Can Jill start the process of meeting the exception and then change her mind? Certainly. And this example will also show you how the risk factors may come into play�
Example: Jill closes out her short position on January 20, 1999, with the intention of holding her "long" position open for the 60-day period and avoiding the constructive sale rules. When Jill closed out her short position, the stock price was still at $75 per share. So Jill had no gain or loss on her short position, and her gain on her original long position remains at $60 a share.
On January 30, 1999, the share price drops to $70, and Jill's heart goes pitty-pat. On February 5, 1999, the share price drops to $60, and Jill's stomach does flip-flops. On February 27, 1999, the share price drops to $50, and Jill decides she's had enough.
She sells out her long position to recoup at least some of her hard-earned gains. But, because Jill didn't wait the required 60 days to close her long position, she is in violation of the constructive sale rules. Jill will be required to report the gain on the sale in 1998 (when the constructive sale took place), and not in 1999 (when the actual sale took place). Jill took the risk�and lost. Which is exactly why hedging transactions and market timing strategies are not part of the Foolish Filosophy.
The constructive sale rules are much more complicated than the simple transaction noted above, but this transaction will certainly be of interest to many people. If you are using any "hedging" transactions, you really need to be aware of the constructive sale rules. You can read more about them in IRS Publication 550 at the IRS website.
[Want to learn more about taxes and investing? The Motley Fool Investment Tax Guide is now available through FoolMart. There is still time available to do that tax planning (and tax saving) before the end of the year. Click here to read more about this Investment Tax Guide.]
Please note that Roy and Dave cannot answer individual questions via e-mail. If you have tax questions, please ask them on the taxes message board. Thanks!
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Please note that Roy cannot answer individual questions via e-mail. If
you have tax questions, please ask them on the taxes message board. Thanks!
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