Short Sales
The topic of short sales does not pertain to options as much as to stocks except that a trader can sell options uncovered, or naked. A naked put (cash secured put) has the same risk profile as a covered call and should be considered as an alternative to qualified covered calls as discussed on the Straddles page.
In my opinion, naked calls should never be considered - there are too many risk-controlled strategies that can provide more than adequate returns rather than entering a trade with virtually unlimited risk.
A discussion of the tax implications of trading stock and options would not be complete without a mention short sales and some of the nuances involved.
Holding Period
The short sale is defined as borrowing stock and selling the shares that the trader has borrowed in anticipation of a price decline. The trader may then purchase the shares and replace the borrowed shares recognizing gain on the difference between the short sale and the purchase to cover.
The holding period of the shares used to cover the borrowed shares generally determines the term of the gain or loss. However, if the trader held “substantially identical property” on the date of the short sale and that property has been held one year or less, then the gain or loss is deemed to be short-term, regardless of the actual holding period of the securities used to cover the sale.
Correspondingly, if the trader has held “substantially identical property” on the date of the short sale and that property has been held more than one year, then the gain or loss is deemed to be long-term.
Substantially Identical Property
So here we are again!! What is “substantially identical property”?
The interesting, and more onerous, fact when dealing with short sales and constructive sales (see below) is that substantially identical has been broadened in its definition to property. Now, the property does not have to be the same security or derivative of the same security, but can be similar property or something that the market deems to be similar property.
Again, Regulations have not been promulgated on this issue but presumably IRS could define the covering of a short position in AAPL with the purchase of QQQ.
I would argue that substantially identical would need to have a beta coefficient within less than 1% of the short stock, compared to a major market index, such as SPX or COMP, over a period of at least one year.
Constructive Sales
If a trader has entered into a short sale that has appreciated in value and subsequently acquires substantially identical property, regardless of Regs 1.1233-1(a )(1) - which states that gain or loss is recognized upon delivery of property that closes the short sale - that significantly reduces both the risk of loss and potential gain, a constructive sale has occurred.
Upon the constructive sale occurrence, gain is recognized as if the entire position were sold at fair market value, presumably the closing prices on the day the substantially identical property is acquired.
The gain recognized is added to the basis of the appreciated property and a new holding period begins.
There are a number of exceptions and date-driven conditions that apply. One of the most significant is that of a married put, which is specifically excepted from short sale treatment.
Dividends Paid on Short Stock
When a trader holds a short position in stock, and that stock pays a dividend, the holder of the short position owes the dividend to the investor from whom the trader borrowed the stock.
Okay, that actually makes sense, but wait, there’s more …
If the short seller has held the position less than 46 days when the dividends are paid, the short seller cannot deduct the payment of the dividends, typically on Schedule A as Investment Interest Expense, but must capitalize the dividends which are added to the basis of shares when replaced. Are you kidding? … but wait, it gets worse …
Now if that is not enough, the owner of the borrowed shares does NOT receive qualified dividends but receives a Payment in Lieu of Dividends at the investor’s marginal tax rate. And the loaning of the shares were chosen by the investor’s brokerage at random and not of the investor’s own choosing.
So, in other words, the rate could theoretically increase from 0% to 15% or 10% to 35% and is reported on the “Other Income” line of Form 1040.
A Payment in Lieu of Dividends is reported on Form 1099-MISC in Box 8 and NOT on Form 1099-DIV.
Reporting Short Sales
Reporting is NOT required until the year in which the trade closes.
For example, you executed a short sale in 2018 and then deliver shares of the shorted stock to your broker in 2019. The sale is reported on Form 8949 in 2019.
Holding period is another somewhat counter-intuitive concept for short sales, but if you think about the definition of "holding period" it makes sense.
Short-term and long-term is determined based upon the length of time the short-seller HOLDS the property (stock) that is delivered to the broker to cover the short sale.
If the covering stock was held for MORE than 1 year, then it would more than likely be reported as a Box D long-term transaction. Box D reflects that the taxpayer received a Form 1099-B and that the transaction was reported to IRS.
On the other hand, If the covering stock was held for 1 year or LESS then it would be reported as a Box A short-term transaction. Box A reflects that the taxpayer received a Form 1099-B and that the transaction was reported to IRS.
On Form 8949, the Proceeds would be the amount of the short sale (less commissions) and the Cost would be the amount paid for the shares delivered to the broker. Date Acquired would correspond to the date the property delivered to the broker was acquired. Date Sold is the date the property was actually delivered to the broker to close the short sale.