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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: of 121585  
Subject: Re: short against the box Date: 7/8/1999 11:39 PM
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[[I have 800 shares of a stock held for several years. Cost basis is zero due to
splits and previous sales.]]

Oops...I don't think so. It's impossible for you to have a zero basis because of splits. It might be very small, but unlikely zero. It you believe that it's zero, it may be than you incorrectly computed your basis when dealing with all of the previous splits. You can read more about how to comput your basis when dealing with stock splits in my multi-part post on this issue in the Taxes FAQ area. You might want to check it out for future reference.

[[ Stock is at all time high, and I would like to lock in some of the profits without
tax liability for this year. If I sell short against the box do I defer the tax until
covering the short after January 1st? At that time can I then keep the 800 shares
and buy other shares to cover the short still maintaining LTCG for the 800
shares?]]

You MAY be able to move the gain to 2000, but certainly not beyond. And you have to be careful not to let the new constructive sale rules will get in your way. You are going to get the long answer, since I'm working on a multi-part post on this very issue for the Taxes FAQ area. So you'll get most of it here. So sit back, relax, and read on.

Prior to the Taxpayer's Relief Act of 1997, transactions designed to reduce or eliminate risk of loss on financial assets generally did not cause income realization. For example, a taxpayer could lock in gain on securities by entering into a "short sale against the box," (i.e., when the taxpayer owns securities that are the same as, or substantially identical to, securities borrowed and sold short). The form of the transaction was respected for income tax purposes and gain on the substantially identical property was not recognized at the time of the short sale. Pursuant to rules that allowed specific identification of securities delivered on a sale, the taxpayer could obtain open transaction treatment by identifying the borrowed securities as the securities delivered. When it was time to close out the borrowing, the taxpayer could choose to deliver either the securities held or newly-purchased securities. The Code provided rules only to prevent taxpayers from using short sales against the box to accelerate loss or to convert short-term capital gain into long-term capital gain or long-term capital loss into short-term capital loss.

In addition, taxpayers could also lock in gain on certain property by entering into offsetting positions in the same or similar property. Under the straddle rules, when a taxpayer realizes a loss on one offsetting position in actively-traded personal property, the taxpayer generally can deduct this loss only to the extent the loss exceeds the unrecognized gain in the other positions in the straddle. In addition, rules similar to the short sale rules prevent taxpayers from changing the tax character of gains and losses recognized on the offsetting positions in a straddle.

In general, a taxpayer cannot completely eliminate risk of loss (and opportunity for gain) with respect to property without disposing of the property in a taxable transaction. However, prior to the Taxpayer's Relief Act of 1997, several financial transactions had been developed or popularized which allowed taxpayers to substantially reduce or eliminate their risk of loss (and opportunity for gain) without a taxable disposition. Like most taxable dispositions, many of these transactions also provided the taxpayer with cash or other property in return for the interest that the taxpayer has given up.

One of these transactions was the "short sale against the box." In such a transaction, a taxpayer would borrow and sell shares identical to the shares the taxpayer held. By holding two precisely offsetting positions, the taxpayer was insulated from economic fluctuations in the value of the stock. While the short against the box was in place, the taxpayer generally could borrow a substantial portion of the value of the appreciated long stock so that, economically, the transaction strongly resembled a sale of the stock held.

Other transactions used by taxpayers to transfer risk of loss (and opportunity for gain) involved entering into notional principal contracts or futures or forward contracts to deliver the same stock. For example, a taxpayer holding appreciated stock could enter into an "equity swap" which required the taxpayer to make payments equal to the dividends and any increase in the stock's value for a specified period, and entitled the taxpayer to receive payments equal to any depreciation in value. The terms of such swaps also frequently entitled the shareholder to receive payments during the swap period of a market rate of return (e.g., the Treasury-bill rate) on a notional principal amount equal to the value of the shareholder's appreciated stock, so that the transaction strongly resembled a taxable exchange of the appreciated stock for an interest-bearing asset.

Pursuant to changes made by the Taxpayer's Relief Act of 1997, taxpayers must recognize gain (but not loss) upon a constructive sale 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:

• a short sale,
• an offsetting notional principal contract, or
• a futures or forward contact.

For a taxpayer who has one of these transactions, a constructive sale occurs when it acquires the related long position. Other transactions will be treated as constructive sales to the extent provided in Treasury regulations (which have not yet been issued).

The constructive sale rules are generally effective for transactions entered into after June 8, 1997.

In applying these rules, any transaction which would otherwise be treated as a constructive sale during the taxable year is disregarded if:

• the transaction is closed before the end of the 30th day after the close of the taxable year,
• the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date such transaction is closed, and
• at no time during such 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.

If a transaction that is closed is reestablished in a substantially similar position, the exception applies provided that the reestablished position is closed prior to the end of the 30th day after the close of the taxable year and if, for the 60 days after closing a transaction, the taxpayer hold the appreciated financial position and at no time is the taxpayer's risk of loss reduced by holding certain other positions.

A transaction that has resulted in a constructive sale of an appreciated financial position (e.g., a short sale) is not treated as resulting in a constructive sale of another appreciated financial position so long as the taxpayer holds the position which was treated as constructively sold. However, when that position is disposed of by the taxpayer, the taxpayer immediately thereafter is treated as entering into the transaction that resulted in the constructive sale (e.g., the short sale) if it remains open at that time. Thus, the transaction can cause a constructive sale of another appreciated financial position at any time thereafter.

Example: Assume a taxpayer holds two stock positions and one offsetting short sale, and the taxpayer identifies the short sale as offsetting one of the stock positions. If the taxpayer then sells the stock position that was identified, the identified short position would cause a constructive sale of the taxpayer's other stock position at that time.

Any of this make sense? I sure hope so. You'll likely see it in more expanded form in the next few weeks in the Taxes FAQ area (with more examples). But I hope that this will answer your immediate question. If not, let me know and I'll try and give you some additional information.

TMF Taxes
Roy

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