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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 121061  
Subject: Re: Shorting Against the Box? Date: 12/8/1998 9:43 AM
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[[I will be in the lowest tax bracket next year (back to being a student) from a higher bracket this
year. I am getting more cautious on the market these days -- i hate this volatility -- but I want to
take my long-term gains next year when they will be taxed at only 10% as opposed to 20% if
possible. How can I lock in my gains at current prices but take the tax consequence next year? Do
I simply short against the box? If so, how do i do it? Thanks for any ideas.]]

The problem is that if you "short against the box", you may turn your long term gains into short term gains. In addition, if you short agains the box, you could run into trouble with respect to the new constructive sales rules.

Gain on closing a short sale is treated as short-term (regardless of the taxpayer's actual holding period for the property used to close the short sale) if the seller (a) owns 'substantially identical' property held for not more than one year at the time of the short sale or (b) acquires 'substantially identical' property after the short sale and on or before the closing date.

Gain on any part of the short sale, however, in excess of 'substantially identical' property held for not more than one year at the time of the short sale or acquired after the short sale and on or before the closing is not limited to a short-term capital gain.

For the purpose of this limitation on long-term capital gains, 'puts' or other options to sell at a fixed price are treated as short sales.

So you can certainly protect your gains, but you may impact the character of your gains. So you need to be careful.

In addition, the constructive sale rules can be a bit confusing.

If there is a constructive sale of an 'appreciated financial position', the taxpayer recognizes gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale (and any gain must be taken into account for the tax year which includes that date). A constructive sale of an appreciated financial position occurs when the taxpayer (or a related person) enters into a short sale (or certain offsetting notional principal contracts or a futures or forward contract) of the same or substantially identical property.

But...there are exceptions to the constructive sale rules. For purposes of the constructive sale rules, any transaction (which would otherwise be treated as a constructive sale) during the tax year is disregarded if:
1. the transaction is closed before the end of the 30th day after the close of the tax year,
2. the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed, and
3. at no time during that 60-day period is the taxpayer's risk of loss with respect to the position reduced by reason of a circumstance which would be described in Code Sec. 246(c)(4) (rules relating to suspension of the holding period where the risk of loss is diminished for purposes of the dividends received deduction) if references to stock included references to the position.

If a taxpayer meets the requirements described in (1) through (3) above, he can engage in transactions such as 'short sales against the box' (i.e., where a taxpayer borrows and sells shares identical to the shares the taxpayer holds) without a constructive sale occurring. But he must remain at risk with respect to the appreciated financial position for the sixty days after the closing.

If a taxpayer fails to meet the requirements for the exception (i.e., by not closing the transaction within 30 days of the close of the tax year), the constructive sale occurs on the date he entered into the transaction.

Presumably, requiring that the appreciated financial position be held for the 60-day period beginning with the closing of the transaction, means the closing can't occur by using the appreciated financial position. Instead, other property must be used. That property could be newly acquired property or other property that the taxpayer held that was not treated as constructively sold. Any gain or loss on the transaction would be short-term capital gain or loss if the property used to close the transaction was not acquired more than one year before the closing.

Example: R, a calendar year taxpayer, has the following transactions in X Corp common stock:
. . . (1) Mar. 1, Year 1: bought 500 shares for $20,000.
. . . (2) Sept. 4, Year 4: borrows 500 shares from her broker and sells those shares short on that date for $40,000.
. . . (3) Jan. 15, Year 5: buys 500 shares for $35,000 and delivers those shares to her broker to close the short-sale transaction.
. . . (4) Mar. 20, Year 5: sells her original 500 shares (the appreciated financial position) for $33,000.

Closing the short sale (transaction (3)) results in a short-term gain of $5,000 on transaction ($40,000 less $35,000).

The sale of her original shares on Mar. 20, Year 5 (transaction 4)) results in a long-term gain of $13,000 ($33,000 less $20,000).

Both the short-term gain of $5,000 and the long-term gain of $13,000 are taken into account in Year 5. There was no constructive sale in Year 4 since R closed the transaction before Jan. 31, Year 5, held her appreciated financial position throughout the 60-day period beginning on Jan. 15, Year 5, the day she closed the short sale made in Year 4, and her risk of loss with respect to her appreciated financial position was not diminished during that 60-day period.

Example: S, a calendar year taxpayer, has the following transactions in X Corp common stock:

. . . (1) Mar. 1, Year 1: bought 500 shares for $20,000.
. . . (2) Sept. 4, Year 4: borrows 500 shares from her broker and sells those shares short on that date for $40,000.
. . . (3) Jan. 15, Year 5: buys 500 shares for $35,000 and delivers those shares to her broker to close the short-sale transaction.
. . . (4) Mar. 10, Year 5: sells her original 500 shares (the appreciated financial position) for $34,000.

S has made a constructive sale in Year 4 on which she has long-term capital gain of $20,000, since she failed to hold the appreciated financial position until at least Mar. 16, Year 5, the day after the 60-day period beginning with the closing of the transaction on Jan. 15, Year 5 ended.

S will have short-term gain of $5,000 on the closing of the short sale (transaction (3)). That's $40,000 (the value of the borrowed stock at the time the shares were borrowed), less $35,000 (the basis of the shares used to close the transaction).

S will have a short-term capital loss of $6,000 on transaction (4), the sale on March 10, Year 5 of the shares S originally held (basis of $40,000 less sale price of $34,000) since S is treated as getting a new holding period for those shares starting on Sept. 4, Year 4 (the date that the constructive sale is entered into) and her basis in the shares is increased by the $20,000 of gain recognized on the constructive sale.

I'm not sure that you expected such a monster answer to (what you probably thought was a very easy question). But any time that you get into "offsetting" positions, you run into some pretty complicated tax law.

If you ARE interested in offsetting positions, check out IRA Publication 550 for additional information. In addition, there are tax guides and books available at your local bookstore that may help you with these complex transactions.

TMF Taxes
Roy

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