From Bill Brinkley, Jr.: “You mentioned a while back that you can effectively ‘cancel out’ your position in a stock by shorting the exact number of shares you own. Somebody told me this a few years ago, and now you’ve got me thinking about it again as a way to lock in some gains on stocks I’d like to sell but don’t want to pay taxes on.”

This is called shorting against the box, from the days when your stock certificates were kept in a safety deposit box.

“My questions are these,” says Bill:

  • “How long can you go on holding a stock both long and short? Forever? Doesn’t the IRS care?”

Forever is a long time, but it used to be the answer. Now, because the IRS does care, it looks as if this loophole may finally be closed as part of the new tax bill — and retroactively to short sales made after May of this year.

  • “When you cover your short, any gains are treated as short-term capital gains, which here in my state creates additional tax to pay. So is the whole shorting plan really a good idea if you do someday have to close out your positions?”

Yes and no. I think the loophole will be closed, as it should be, so this may all be moot. And I should also point out the pothole in the loophole, lest you get any grand ideas: even under existing law, shorting against the box freezes your holding period. That is, if you held a stock 11 months and it hadn’t yet qualified as a long-term capital gain, shorting against the box would stop the clock unless and until you covered your short. So you can’t use this ploy to lock in a profit and see it risklessly mature as “long-term.”

The advantages are (or used to be) the ability to defer tax to a year when you’d be in a lower bracket, either because — in your case — you might someday be moving to a state with a lower income tax and/or because you expect the federal tax rate to come down. Shorting against the box allowed you to shift a gain into a year when it would be less heavily taxed.

Another possible advantage: Say you bought Coke at $10 and it’s $70 and you love it for the long term and certainly don’t want to trigger a huge tax by selling it . . . yet you think it’s likely to fall back a bit and you’re not happy about that. So you short some against the box, cover for a short-term gain at $60 or $55 or wherever, while you continue to hold your stock. I’m definitely not suggesting you do this, especially now with the new tax law, but that’s one way the strategy could have made sense.

Then again, there is the potential for this ploy to transform a lightly-taxed long-term capital gain into a more heavily taxed short-term gain. It’s not likely to happen with Coke, but continuing with this example, say the stock fell from $70 back to $10, where you bought it — or even to zero, when it turned out that Coke causes some dread disease and that Atlanta knew it all along. Well, you have a huge profit in your short — but, as you say, even if you held it for 30 years, it’s considered a short-term gain. And you’ve let the long-term gain in the shares you’re long wither away to nothing. So you’ve transformed a lightly taxed gain into a heavily taxed gain. Oops.

  • “When the tax year ends and you’re holding a short position, the 1099 from your broker contains a Total Sales for the Year amount. This amount includes sales of the stock you borrowed to create the short position. And you have to put this total amount on your Schedule D. How do you explain to the IRS (year after year) that some of that money was from short sales and there’s no gain or loss yet to report? (Because the Total Sale Price column won’t add up to the 1099’s figure.)”

No different from any other short sale. You just attach a little footnote to your return. (Or not, and if it ever comes up in an audit, you just explain, “Oh, that was a short sale.”)

But let me say once more: it looks as if this loophole may finally be closed — retroactively. So if you hold a stock you think you should sell, I’d just sell it. If you own one you think is a good long-term holding but has gotten way ahead of itself, you might consider writing calls against it or buying a put.

Tomorrow: The New Tax Bill



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