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Author: fling Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: capital gains when you short Date: 7/13/1999 7:30 PM
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I exercised and held a good deal of my former company's ISO's, and the stock's gone up quite a bit. I haven't yet fulfilled the 1-year holding requirement, and my income for this year is abnormally high due to ISO's I exercised and sold cashlessly, so I'd like to avoid selling them if I could.

I heard about shorting stocks, and wondered if that's a viable option. What are the tax implications for shorting a stock?

If I short it, and it continues to go up, can I use some of the exercised ISO's to cover the short? (I imagine I can ask my broker, but figured I'd ask here too, while I'm at it) If so, what are the tax implications of that?

Mucho thanks!
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Author: Bob78164 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17279 of 121061
Subject: Re: capital gains when you short Date: 7/13/1999 8:30 PM
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fling writes (in part):

[M]y income for this year is abnormally high due to ISO's I exercised and sold cashlessly . . . .

I reply:

This isn't your question, but have you looked at AMT issues? Exercising stock options is a classic way to get bitten, and AMT can be an ugly surprise come tax time if you didn't see it coming. I don't know whether your situation triggers AMT or not, but I am suggesting that you look into it. --Bob

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Author: mathetes Big red star, 1000 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17280 of 121061
Subject: Re: capital gains when you short Date: 7/13/1999 8:49 PM
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I exercised and held a good deal of my former company's ISO's, and the stock's gone up quite a bit. I haven't yet fulfilled the 1-year holding requirement, and my income for this year is abnormally high due to ISO's I exercised and sold cashlessly, so I'd like to avoid selling them if I could.

Bob already posed the question I wondered about: AMT. You say you held "a good deal... of the ISOs." If that good deal involved bargain element gains of $30,000 or more, then you pretty definitely are in AMT territory. Assuming you also have other preference items on your tax return (state and local tax deductions, real estate tax deductions, for example), you will be incurring AMT if those preference items and the bargain element here from your ISOs exceeds $30 to $35,000.

I don't know what the complications might be if you start combining with covering short sales. More importantly, the two actions together are quite incongruous. People normally buy ISOs on the premise that they're going up; they short stock on the premise that it's going down. Doing the two actions in concert sounds like shooting from the hip and getting yourself in the foot.

Covering would pretty certainly be a "disqualifying disposition" of the ISOs, if it's within 12 months, exposing you to normal income tax on the bargain element, instead of AMT.

You would be well advised to talk to somebody in whom you can place your trust, and talk about the amounts involved, do some what-if scenarios, and so on.

mathetes

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Author: fling Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17281 of 121061
Subject: Re: capital gains when you short Date: 7/13/1999 9:09 PM
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Thanks for the info.

Bob already posed the question I wondered about: AMT.

Well, I am aware of AMT's existence, but I haven't run any numbers. All I know is that I'm probably over the limit. Does that make this whole thing moot? Should I sell some options to get the gains categorized as income instead of triggering AMT? I've assumed that the AMT rate on the options would be less than the income tax rate (especially for this year).

People normally buy ISOs on the premise that they're going up; they short stock on the premise that it's going down. Doing the two actions in concert sounds like shooting from the hip and getting yourself in the foot.

When I exercised and held, I believed it would go up. Well, I was right, but it's gone up a lot faster than I expected, so I was considering whether I could use a short sale as a hedge. My thinking was that if it corrects, everything's hunky dory. If it keeps going up too far, I cover with the options, and it's just as if I originally sold them.

You would be well advised to talk to somebody in whom you can place your trust, and talk about the amounts involved, do some what-if scenarios, and so on.

Okay, thanks!


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Author: Bob78164 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17282 of 121061
Subject: Re: capital gains when you short Date: 7/13/1999 9:15 PM
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fling writes (in part):

When I exercised and held, I believed it would go up. Well, I was right, but it's gone up a lot faster than I expected, so I was considering whether I could use a short sale as a hedge.

I reply:

Wouldn't buying a put option be a simpler hedge? Or would that cost more? (I've never bought or sold an option in my life, so this discussion remains academic for me. I also don't know what tax effects, if any, the purchase of an offsetting put option would have.) --Bob

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Author: WilliamLipp Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17287 of 121061
Subject: Re: capital gains when you short Date: 7/14/1999 12:29 AM
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fling Date: 7/13/99 9:09 PM Number: 17281
Well, I am aware of AMT's existence, but I haven't run any numbers. All I know is that I'm probably over the limit. Does that make this whole thing moot? Should I sell some options to get the gains categorized as income instead of triggering AMT?

As others have said, find someone that knows the real answer. I've not been in this situation, but listening with half an ear to friends, I think it works like this: You're going to be keeping two sets of tax books - the amount you would have owed, and the amount you owe because of AMT. As long as the AMT amount is higher, you will pay the AMT amount. But if, at some future date, the AMT amount gets lower than the regular tax, you start to recover the AMT. In effect, you pay the lower AMT tax in that future year until such time as the total taxes paid at AMT rates for all years becomes less that total taxes you would have paid at regular rates for those years. So assuming you will eventually be out of AMT range, perhaps by retiring young, you will eventually pay regular tax amounts, and should still be paying attention to long term holds of the stocks. The practical problem most people face is that this strategy doesn't generate cash in year one, while the AMT taxes generate expenses in year one. This may not be correct in all details - in fact in might be totally wrong - so use it as a basis for your own investigation, not as a guide.

so I was considering whether I could use a short sale as a hedge. My thinking was that if it corrects, everything's hunky dory.

Again, I'm not positive about this. But I think is the strategy known as shorting against the box, and I think the long term holding rules say, in effect, that this time period doesn't count towards long term capital gains, so it doesn't work as a way to lock in gains while waiting for them to age - the gains are locked in, but they don't age.

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Author: mathetes Big red star, 1000 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17293 of 121061
Subject: Re: capital gains when you short Date: 7/14/1999 7:53 AM
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Should I sell some options to get the gains categorized as income instead of triggering AMT? I've assumed that the AMT rate on the options would be less than the income tax rate (especially for this year).

You really need to do some what-if analysis with TaxCut or TurboTax or, especially if the dollars are significant, a tax specialist. In general, you are better off with AMT than with regular income tax. I think of AMT as prepaid long term capital gains taxes; it's typically in the same range (approx. 20-25%), which is probably lower than your Federal rate for normal income (an assumption predicated on the fact that you have significant options, which is typically true only of highly compensated people).

So it usually would not make sense to incur a disqualifying disposition by selling stocks acquired through exercising an ISO prior to the one year + one day holding period.

By the way, there's a website -- www.fairmark.com -- where there's a lot of useful information on ISOs, AMT, and related subjects. Written by a tax lawyer but still in comprehensible English.

When I exercised and held, I believed it would go up. Well, I was right, but it's gone up a lot faster than I expected, so I was considering whether I could use a short sale as a hedge. My thinking was that if it corrects, everything's hunky dory. If it keeps going up too far, I cover with the options, and it's just as if I originally sold them.

What's your time frame here? And what do you think the company is going to do over the long term? Even if it should fall (correct) in the short term. You sound just a little like the proverbial "I want to eat my cake and have it too" situation. I have heard of hedging, in the kind of situation you're in, with puts and calls; I have no direct experience with such strategies. I know my company specifically directs all current employees not to participate in such strategies; since you said you are now a "former" employee, such restrictions may not apply, but you might want to check, especially if you were in any kind of "insider" or close to insider position.

mathetes

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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17358 of 121061
Subject: Re: capital gains when you short Date: 7/15/1999 7:23 PM
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[[Wouldn't buying a put option be a simpler hedge? Or would that cost more?
(I've never bought or sold an option in my life, so this discussion remains
academic for me. I also don't know what tax effects, if any, the purchase of an
offsetting put option would have.)]]

In my current featured article in the Taxes FAQ area (The Constructive Sale Rules) deals with this issue. The problem is that I haven't yet written Part IV of the article that deals with options and appreciated financial positions. But I should have it done by tomorrow...and I'll try to remember to post it up here in the folder for my friends to see an "premier" of those issues.

TMF Taxes
Roy

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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17359 of 121061
Subject: Re: capital gains when you short Date: 7/15/1999 7:32 PM
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[[Again, I'm not positive about this. But I think is the strategy known as shorting
against the box, and I think the long term holding rules say, in effect, that this
time period doesn't count towards long term capital gains, so it doesn't work as
a way to lock in gains while waiting for them to age - the gains are locked in, but
they don't age.]]

Basically correct. Ignoring the ISO issues for a second, and just looking at the "short against the box" issues, shorting will lock in the gain, but will NOT help you as far as holding period.

If your "long" position is short term when you "short/box", then it will always remain short term while the hedge is open. When you sell the "short" position, if you decide to keep your "long" position, it'll still be a short term gain...even if you held the original "long" position for more than a year (when including the "short/box" position.

Does this make any sense? I'll try an example.

You buy 100 shares of XYZ at $10/share on January 10, 1998. On December 1, 1998, the price of XYZ is $90/share. So you borrow a separate 100 shares from your broker, and sell them short. A classic "short agains the box" move.

On December 25, 1999 you sell your short position. Because the long position that you originally had was short term at the time of the "hedge", the gain or loss on the short sale will also be short term...regardless of how long you held the "short" open. In this example, you held the short position for over a year, but any gain or loss would be short term.

If you turned around and also sold your long position on December 25, 1999, any gain or loss would also be short term...because your holding period was short term when you initiated your "hedge" position. If you decided...for whatever reason...that you wanted to hold on to your "long" position, your NEW holding period would begin on December 25, 1999...when you closed your "hedge". You do NOT get to tack on the 11 months that you originally held the shares (prior to your hedge) to your "new" long position. Your holding period begins all over again on the date that you closed your "hedge" position.

Make any more sense? If not, please ask. You can read more about this issue in IRS Publication 550 at the IRS web site.

TMF Taxes
Roy

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Author: fling Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17424 of 121061
Subject: Re: capital gains when you short Date: 7/17/1999 1:35 PM
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Does this make any sense? I'll try an example.

Yes, I think I understand. Anyway, even though I believe in the long-term prospects of the company, I decided I couldn't stomach that much of my portfolio (even if it wasn't my original money) in one stock for that long just to avoid the ISO income tax, so I sold half of it and will just hang onto the rest.

Thanks much for the info!

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Author: mathetes Big red star, 1000 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17425 of 121061
Subject: Re: capital gains when you short Date: 7/17/1999 1:52 PM
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I decided I couldn't stomach that much of my portfolio (even if it wasn't my original money) in one stock for that long just to avoid the ISO income tax, so I sold half of it and will just hang onto the rest.

That sounds just a tad rash; this from someone who has experienced the downside of AMT at its worst. It still is considerably less than the regular income tax you will owe at having created now a disqualifying disposition for those stocks you've sold. (I believe you said you'd not yet met the long term holding period). It's all academic at this point for you, but for the sake of others reading, this amateur's advice would be to carefully consider the lower taxes you pay just by holding those ISOs for a year and a day and then selling the amount you need to pay for the transaction and the AMT, whatever debt you may have incurred. Your AMT rate is typically 5 to 10% less than the regular income tax rate.

Granted that what you did here avoids AMT, but AMT is not the worst fate in the world; it's easy to get scared by the horror stories, which are more (again I speak from experience) because people weren't adequately informed in advance......

Anyway -- good luck in your new career/retirement.

mathetes

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Author: fling Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17474 of 121061
Subject: Re: capital gains when you short Date: 7/19/1999 12:34 PM
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That sounds just a tad rash; this from someone who has experienced the downside of AMT at its worst. It still is considerably less than the regular income tax you will owe at having created now a disqualifying disposition for those stocks you've sold. (I believe you said you'd not yet met the long term holding period).

Oh, I didn't sell cuz of the AMT, but because the stock went up even more, pushing it up to 40% of my portfolio. I think even Warren Buffet never had much more than 30% in Coke. :)

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Author: mathetes Big red star, 1000 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17476 of 121061
Subject: Re: capital gains when you short Date: 7/19/1999 1:06 PM
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Oh, I didn't sell cuz of the AMT, but because the stock went up even more, pushing it up to 40% of my portfolio. I think even Warren Buffet never had much more than 30% in Coke. :)

I use Warren Buffet as a reference point too, when it comes to developing a sound philosophy for long term investing. There's a difference here, however, that should be recognized: Warren Buffet didn't start with a significant portion of his wealth in the form of Incentive Stock Options.

While I think it's hard to argue with his approach in terms of the stocks that I actually buy, not putting too many of those eggs in one basket, I tend to view the stock that is "given to me," -- even though, yes, we need to lay out a little cash to exercise those ISOs -- in a different category. In connection with it, my goal is to maximize its value by minimizing the share that goes to taxes. The goal is to diversify, to accomplish that by selling off at an appropriate pace, and to avoid shooting myself in the foot at the same time.

In your case, again assuming I've read your notes accurately, you sold before holding for a year and a day, meaning you are paying regular income taxes on that set of ISOs, rather than the long term capital gains rate. While your objective of diversification is a valid one, your method of getting there sounds (if I've read you accurately) unBuffetlike (i.e., rash). This is particularly so if you are quite confident that the company is going to continue to improve its price.

Obviously that's just my opinion, and there is risk associated with keeping more than 40% in any one company. You seem to me to have assured yourself of a known higher tax rate while avoiding the possibility (which you seem to think is low probability to begin with) that that portion of your nest egg could fall in value over the next several months. Or is there something I'm missing in this? Am I wrong about the short term holding period?

(One reason I'm pursuing this is that I'm in the same situation (just in case that's not clear), but I've opted to do my divesting and diversifying more slowly.)

mathetes

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Author: mathetes Big red star, 1000 posts Old School Fool Motley Fool One Everlasting Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17478 of 121061
Subject: Re: capital gains when you short Date: 7/19/1999 1:16 PM
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I think even Warren Buffet never had much more than 30% in Coke. :)

P.S. to my last note (one of those, "Oh, I shoulda said this....." situations)

Perhaps a more apt comparison is that other fella on the most wealthy lists, forget his name at the moment, but the one who started his own company, that software company, SmallSoft or something like that.

Anyway, you and I and all the other people who are lucky enough to receive stock options as part of our belonging to a company, often have significant portions of our net worth tied up in that company. That's why the companies give options, in part, to give you a chance to see and enjoy the fruits of your labor. Now, yes, all financial advisors recommend diversifying, absolutely, but you clearly don't want to go to the extreme of, say, allowing options to expire unused for some spurious purist reasoning that exercising them would put your asset allocation out of whack.

mathetes

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Author: fling Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 17480 of 121061
Subject: Re: capital gains when you short Date: 7/19/1999 1:27 PM
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In your case, again assuming I've read your notes accurately, you sold before holding for a year and a day, meaning you are paying regular income taxes on that set of ISOs, rather than the long term capital gains rate. While your objective of diversification is a valid one, your method of getting there sounds (if I've read you accurately) unBuffetlike (i.e., rash). This is particularly so if you are quite confident that the company is going to continue to improve its price.

Yes, you've read correctly. Well, my original plan was to hold the whole thing more than a year, treating, as you said, like the whole thing was a gift. But several friends of mine urged me to treat it like it's my money, since I do own them now. Then as the stock price has gone up much faster than I expected (it's at now where I thought it would be a year from now), pushing up its percentage of my net worth, I did get a bit nervous, which was why I wanted to see if shorting would avoid the problem.

Oh well. Anyway, thanks for the advice. I'll try to keep from doing anything rash again if the stock jumps up again.

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