Dividends Paid On Short Sales

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By Roy Lewis

You decided to short a stock that pays dividends. While you held your short position, you find that a dividend was paid on the stock. Your broker notified you of that fact, and reduced your cash position in your account by the amount of the dividend.

You are now going through your records to prepare your Schedule D for gains and losses, and you run across this little gem. Where do you report this payment? Is it an adjustment to the basis of the stock in the short sale? Or is it a period expense that can be deducted immediately, even if the short position was not closed in the tax year you're filing. What's a mutha to do?

Here is the rule...

If you borrow stock to make a short sale, you might have to remit payments to the lender in lieu of the dividends distributed while you maintain your short position. You can deduct these payments only if you hold the short sale open at least 46 days and you itemize your deductions.

If you close the short sale by the 45th day after the date of the short sale, you can't deduct the payment made to the lender in lieu of the dividend. Instead, you must increase the cost basis of the stock used to close the short sale by that amount.

To determine how long a short sale is kept open, don't include any period during which you hold, have an option to buy, or are under a contractual obligation to buy substantially identical stock or securities. In addition, don't include any period during which you are considered to have diminished your risk of loss from the short sale by reason of holding one or more other positions in substantially similar or related properties.

To deduct these expenses, they are treated as investment interest expenses, and are subject to all of the rules and regulations involving investment interest expense. Report these expenses on Schedule A.

Example: You "short" 100 shares of XYZ company on February 1st for $10/share. On February 15th, your broker notifies you that your account will be reduced by $50 for the dividend paid by XYZ company to its shareholders. On March 10th, you close your short position by buying 100 shares of XYZ at $8/share. Since the short position was not open for at least 46 days, you cannot use the $50 in-lieu-of-dividend payment as a current expense. Rather, this $50 is added to the price of the stock that you purchased to close the position. In the example above, your net gain on your short position would be $150 ($1,000-($800+$50)=$150).

Let's use the same example, but change the dates. Let's say that you don't close the short position until May 15th. In this case, the in-lieu payment of $50 would be treated as "investment interest," deductible on Schedule A, and your "regular" gain on the closing of the short position would be $200.

Now, this might not make much difference during the year, but at year-end, it might make the difference between a current-period deduction and an adjustment to basis.