Category: Short selling

Investment Fees Are Not Deductible But Borrow Fees Are

July 12, 2018 | By: Robert A. Green, CPA | Read it on

The Tax Cuts and Jobs Act suspended “certain miscellaneous itemized deductions subject to the two-percent floor,” which includes “investment fees and expenses.” However, the new law retained “other miscellaneous deductions” not subject to the two-percent floor, including short-selling expenses like stock borrow fees.

While individual taxpayers may no longer deduct investment fees and expenses on Schedule A starting in 2018, they are still entitled to deduct investment interest expenses, up to net investment income, as calculated on Form 4952.

The new law (page 95) has a complete list of suspended miscellaneous itemized deductions including “expenses for the production or collection of income.” That list does not include short-selling expenses. Section 67(b) excludes certain deductions from the “2-percent floor on miscellaneous itemized deductions;” including (8) “any deduction allowable in connection with personal property used in a short sale.”

Carrying charges vs. itemized deductions
Because investment fees and expenses are no longer deductible, some accountants might consider a Section 266 election to capitalize investment management fees as “carrying charges” to deduct them from capital gains and losses. But that won’t work: The IRS said taxpayers could not capitalize investment management fees under Section 266 because they are managerial rather than transactional.

Short-sellers probably could capitalize borrow fees under Section 266 because they are transactional. However, it’s safer to deduct these short-sale costs as “Other Miscellaneous Deductions” on Schedule A (Itemized Deductions) line 28. The new tax law suspended the Pease itemized deduction limitation, so the deduction has full effect on lowering taxable income. One concern: The IRS lists all Section 67(b) exclusion items in the instructions for Schedule A line 28, but it left out (8) for short-sale expenses. The code has substantial authority, and it’s reasonable to conclude that Schedule A instructions for other miscellaneous deductions on line 28 are not an exhaustive list.

Stock borrow fees
Short selling is not free; a trader needs the broker to arrange a loan of stock.

Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Some brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are “other miscellaneous deductions” on Schedule A line 28 for investors. Borrow fees are business expenses for traders qualifying for trader tax status (TTS). Borrow fees are not interest expense, so investors should not include them in investment interest expense deductions on Schedule A line 14.

It’s a significant distinction that has a profound impact on tax returns because investment expenses face greater limitations in 2017, and suspension in 2018 vs. investment interest expenses which are deductible up to investment income. Other miscellaneous deductions, including borrow fees, reported on Schedule A line 28 remain fully deductible for regular and alternative minimum tax (AMT).

Investment management fees cannot be capitalized
In a 2007 IRC Chief Counsel Memorandum, the IRS denied investors from capitalizing investment management fees paid to a broker as carrying charges under Section 266. Investors wanted to avoid alternative minimum tax (AMT) and other limitations on miscellaneous itemized deductions, the rules in effect before 2018. The problem is worse in 2018 with investment expenses entirely suspended.

The memo stated:

  • “Consulting and advisory fees are not carrying charges because they are not incurred independent of a taxpayer’s acquiring property and because they are not a necessary expense of holding property.
  • Stated differently, consulting and advisory fees are not strictly analogous to common carrying costs, such as insurance, storage, and transportation.”

Borrow fees might be able to be capitalized
Borrow fees seem to meet the requirements raised in the 2007 IRS Chief Counsel Memorandum for capitalization as carrying charges under Section 266. (It’s safer to deduct them as “other misc. deductions” on Schedule A line 28.)

Treasury Regulations under 1.266-1(b)(1) highlight several types of expenses that qualify as carrying charges, including taxes on various types of property, loan interest for financing property, costs to construct or improve the property, and expenses to store personal property.

A short seller cannot execute a short sale without borrowing securities and incurring borrow fees; they are a “necessary expense of holding” the position open, and “not independent” of the short-sale transaction. Borrow fees are not for the “management of property,” they are for the “acquisition, financing, and holding” of property.

Investment fees vs. brokerage commissions
Investors engage outside investment advisors and pay them advisory fees including management fees and/or incentive fees. Other investors may pay a broker a flat or fixed fee. These costs are managerial and not transactional, based on how many trades the manager makes. They cannot be capitalized under Section 266 according to the above IRS memorandum.

Brokerage commissions are transaction costs deducted from sales proceeds and added to cost basis on brokers’ trade confirmations and Form 1099-Bs. This tax reporting for brokerage commissions resembles a carrying charge.

Short-seller payments in lieu of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender — the rightful owner of the shares. After the short seller gets these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense.

Section 263(h) “Payments in lieu of dividends in connection with short sales” require the mandatory capitalization of these payments if a short seller holds the short position open for 45 days or less (one year in the case of an extraordinary dividend).

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense.

Investment interest expenses
Section 163(d)(3)(c) states, “For purposes of this paragraph, the term ‘interest’ includes any amount allowable as a deduction in connection with personal property used in a short sale.” A broad reading of “any amount” could be construed as opening the door to borrow fees, but I doubt that. “Any amount” refers to dividends in lieu of dividends held more than 45 days.

Under certain conditions, Section 266 allows capitalization of interest to finance a property.  Short sellers and others might want to consider the possibility of a Section 266 election on investment interest expense, too — especially if they plan a standard deduction or don’t have sufficient investment income. Excess interest is a carryover to subsequent tax years.

Transactional vs. managerial expenses
The following investment expenses seem transactional, and therefore eligible for capitalization in Section 266: Storage of precious metals or cryptocurrency, borrow fees on short sales, excess risk fees on short sales, and margin interest expenses.

The following investment expenses seem to be managerial rather than transactional, and therefore cannot be treated as carrying charges under Section 266: Investment management fees, fixed or flat fees paid to brokers, computers, equipment, software, charting, education, mentors, coaching, monthly data feed fees, market information, subscriptions, travel, meals, supplies, chatrooms, office rent, staff salaries and employee benefits, accounting, tax and legal services, and most other trading-related expenses.

Section 266 election statement and tax reporting

Consider filing a Section 266 election statement with your tax return, including on an extension.

  • “For tax-year 2018, taxpayer herewith elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize short-selling expenses as carrying costs applied to capital gains and losses.”

Explain the election and tax treatment in a tax return footnote.

Report short-selling expenses for realized (closed) short sales as “expenses of sale or exchange” on Form 8949 (Sales and Other Dispositions of Capital Assets) in column (g) “adjustment to gain or loss.” Defer borrow fees paid on unrealized (open) short sales until realized (closed) in the subsequent year.

Consult a trader tax expert on using this potential alternative solution. If you get full deductibility on Schedule A, it’s safer to skip Section 266 capitalization, which the IRS might scrutinize.

Trader tax status
If a short-seller qualifies for trader tax status, then stock borrow fees and other short-selling expenses are deductible as business expenses from gross income.

If a TTS trader engages an outside investment manager, then investment advisory fees remain investment expenses.

Darren L. Neuschwander, CPA and Roger Lorence, JD contributed to this blog post.

Webinar July 19, 2018: Investment Fees Are Not Deductible But Borrow Fees Are. Recording available afterward. Click here.

Related blog posts: Short Selling: How To Deduct Stock Borrow Fees and Short Selling: IRS Tax Rules Are Unique.

 


Short Selling: How To Deduct Stock Borrow Fees

September 19, 2016 | By: Robert A. Green, CPA | Read it on

Traders like to go long and short to play both sides of the market. The IRS has special tax rules for short sellers, and in this blog post, I focus on how to deduct stock borrow fees vs. interest expenses.

Stock borrow fees and loan premiums
Short selling is not free; a trader needs the broker to arrange a loan of stock from another account holder. Brokers charge short sellers “stock borrow fees” or “loan premiums.” Tax research indicates these payments are “fees for the temporary use of property.” Watch out: Many brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For tax purposes, stock borrow fees are miscellaneous other deductions for investors on Schedule A line 28, and Section 162 business expenses for traders qualifying for trader tax status (TTS). Stock borrow fees are not “interest expense” so investors can’t include them in “investment interest expense” deductions.

Support for this tax position
According to New York City tax attorney Roger D. Lorence: “Short sale expenses (stock borrow fees) are not investment interest expense. To support any interest deduction, there must be a valid interest-bearing obligation under state or federal law. (See Stroud v. U.S.) The IRS has ruled that short sales do not give rise to an interest-bearing indebtedness (Revenue Ruling 95-8, 1995-1 CB 107). Rather, the short sale borrower has a liability under state law to return the borrowed stock and pay fees, but this is not interest expense. This is why short sales do not give rise to Section 514 UBIT (no debt-financed property), which is the specific code section in issue in the ruling. The revenue ruling is based on Deputy v. du Pont. The du Pont case applies by analogy here because there can be no interest expense generated in a short sale.”

Tax treatment of borrow fees
Investors are entitled to deduct “investment interest expenses” on Schedule A (Itemized Deductions) line 14, “investment expenses” on Schedule A line 23 and “other miscellaneous deductions” on Schedule A line 28. Borrow fees, and other short-selling expenses are miscellaneous other deductions on line 28. It’s important to differentiate between investment interest expenses vs. investment expenses vs. miscellaneous other deductions because they have different tax treatments.

Taxpayers carry over unused investment interest expense to the subsequent tax year(s), whereas they may not carry over unused investment expenses or miscellaneous other deductions, which means they may entirely lose some of those if they have negative taxable income. Calculate investment interest expense on Form 4952 where it’s limited to net investment income, with the balance carried over. Net investment income is portfolio income minus investment expenses and short-selling expenses. (Read Form 4952 instructions for further details.)

Investment expenses are “miscellaneous itemized deductions” in excess of 2% of adjusted gross income (AGI), and they are not deductible for the alternative minimum tax (AMT). Miscellaneous other deductions on line 28 are not subject to the 2% floor, and they are deductible for AMT. They are superior to investment expenses. Most itemized deductions are subject to a phase-out for the upper-income brackets (known as the Pease limitation, indexed for inflation); some taxpayers are better off using the standard deduction than the itemized deduction. Investment fees and expenses are considered investment expenses.

For traders eligible for trader tax status, short-selling expenses including borrow fees are business expenses.

MORE: Tax treatment for selling short

Easy vs. hard to borrow fees
Very liquid securities are “easy to borrow,” and many brokers charge small fees to short sellers for lending out those shares. Non-liquid securities are “hard-to-borrow” and brokers update their “hard to borrow lists.” Brokers charge higher “hard to borrow fees,” and most publish those rates with sample calculations on their websites. Hard to borrow fee rates rise as demand for shorting increases. A few brokers specialize in finding very hard to borrow stocks, and they charge “up front borrow fees” in addition to hard to borrow fees.

Brokers conflate stock borrow fees with interest expenses
There is a lack of clarity in separating stock borrow fees from interest expenses. The distinction matters since borrow fees are miscellaneous other deductions, whereas interest is an investment interest expense.

I wonder if some brokers prefer using the term interest expense since customers may find that more logical with borrowing shares under securities lending agreements, and because it leads to better tax treatment. Customers may also object to paying significant fees.

For example, one leading online broker calls the “interest rate charged on borrowed shares” a “fee rate” and also “net short stock interest.” This broker does not report the fees on Form 1099.

A few other online brokers mention interest on shorted shares as a “fee rate.” They report “miscellaneous non-reportable deductions” on Form 1099; not interest expense.

One of the largest online brokers states on its website: “When you borrow the shares, you pay interest to the brokerage house for this loan, and the harder the shares are to find, the higher the interest rate.” I called customer support, and a support person admitted it’s a stock borrowing fee and not interest expense.

It would be helpful if brokers cleaned up their language to be clear about stock borrow fees vs. interest expense.

Active traders using Section 475 have it easy
Active traders qualifying for trader tax status (TTS) with a Section 475 election have an easy time reporting short-sale trades and related expenses, and they maximize tax advantages. They are unaffected by special rules for short sales for constructive sales on appreciated positions and holding period rules. (Section 475 is tax beneficial because it exempts traders from the $3,000 capital loss limitation against other income, wash-sale losses, and short sale adjustments.)

With Section 475 mark-to-market accounting, traders impute sales at year-end on open positions. That negates the need to make “constructive sales on appreciated positions” from selling short against the box. Short-term vs. long-term holding periods are not an issue with Section 475. TTS unlocks Section 162 business expense treatment, so expenses related to selling short (including stock borrow fees and interest expense) are deductible as business expenses from gross income. Sole proprietors use Schedule C for reporting business expenses.

Example of a trader with TTS
I recently worked with a client who had a $800,000 net short-term capital gain from selling short during 2015 and $500,000 of stock borrow fees (probably high for a short seller). He hoped the effect on his taxable income would be $300,000 ($800,000 less $500,000) as that was his economic gain. But, his accountant told him taxable income was considerably higher after applying the Pease itemized deduction limitation. The client qualified for TTS, and therefore could report his stock borrow fees along with other trading business expenses on Schedule C. His taxable income effect was under $300,000.

But, his Schedule C would look like an enormous red flag since it reported trading business expenses only, and that amount was a loss over $500,000. He entered capital gains and losses on Form 8949, transferred to Schedule D. In Green’s 2016 Trader Tax Guide, I suggest moving a portion of business trading capital gains to Schedule C to zero it out. We also recommend a footnote explaining that the taxpayer is profitable and the transfer of income to Schedule C. Additionally, the note explains what trader tax status is by law, how the client qualified for TTS, and how to treat selling-short expenses.

Example of an investor
Another client has a net capital loss of $100,000. After the $3,000 capital loss limitation against other income, he has negative taxable income, which means he will not get any tax benefit from his stock borrow fees.

Postscript on July 12, 2018: In the original post, I stated borrow fees were “investment expenses” included in “certain miscellaneous deductions” reported on line 23, subject to the 2-percent floor and AMT preference. The Schedule A instructions did not list short-selling expenses in “other miscellaneous deductions” reported on line 28, excluded from the 2-percent floor.

In this revised version, I offer an alternative analysis: Section 67(b) excludes “other miscellaneous deductions” from the “2-percent floor on miscellaneous itemized deductions;” including (8) “any deduction allowable in connection with personal property used in a short sale.” Borrow fees fit the definition of Section 67(b)(8). The code has substantial authority, and it’s reasonable to conclude that Schedule A instructions for other miscellaneous deductions on line 28 are not an exhaustive list.


Short Selling: IRS Tax Rules Are Unique

| By: Robert A. Green, CPA | Read it on

The essence of trading is buying and selling financial products for income. If you think the asset will rise in value, buy first and sell afterward — this is what’s known as a “long position.” If you want to speculate on the asset declining in value, borrow the security to sell it first, and buy it back later to close the short position — this is “selling short.” (There are other ways to speculate on market drops like buying put options or inverse ETFs, both of which are long positions.)

In this blog post, I cover the tax treatment for selling short. There are two types of short sales: (1) a short sale and (2) a short sale against the box. Both involve borrowing securities from another account holder, arranged by a broker.

Constructive sales on appreciated positions
In the old days, owners stored stock certificates in safe deposit boxes. They could borrow and sell securities, but not the ones stored in their box — hence the moniker, “short sale against the box.” It became a popular tax shelter to defer capital gains taxes.

The Taxpayer Relief Act of 1997 mostly closed the deferral loophole by adding new Section 1259 Constructive Sales Treatment For Appreciated Financial Positions. Before these changes, a trader could own security A with a large unrealized capital gain and short it against the box before year-end to economically freeze the capital gain, but defer realization of the capital gain until the following year. Exception: A trader can still achieve tax deferral on an open short against the box position at year-end if he buys to cover the open short position by Jan. 30 and leaves the long position open throughout the 60-day period beginning on the date he closes the transaction — so there is an economic risk.

An example from Pub. 550 Investment Income and Expenses, Short Sales:
“On May 7, 2015, you bought 100 shares of Baker Corporation stock for $1,000. On September 10, 2015, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2015 and the first 30 days of 2016. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins on September 10.”

The constructive sale rules apply on substantially identical properties, which includes equities, equity options (including put options), futures and other contracts. For example, Apple equity is substantially identical with Apple call and put equity options. Traders use a bevy of financial products, and they may inadvertently trigger Section 1259 constructive sales. Report gains on constructive sales, not losses.

Brokers do not report constructive sales on appreciated positions on Form 1099-Bs. Traders need to make manual adjustments on Form 8949. I recommend using tax-compliant software or a service provider that uses a tax-compliant software.

Special rules for short-term vs. long-term capital gains and losses
Most traders understand capital gains rules for long positions. For securities using the realization method, a position held for 12 months or less is a short-term capital gain or loss subject to marginal ordinary tax rates (up to 39.6% for 2015 and 2016). A position held for more than 12 months is a long-term capital gain with lower capital gains tax rates (up to 20% for 2015 and 2016).

According to Pub. 550, “As a general rule, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount of time you actually hold the property eventually delivered to the lender to close the short sale.”

If you sell short without owning substantially identical property (stock or option) in your account, the holding period starts when you later buy the position to close the short sale. The holding period is one day, so it’s a short-term capital gain or loss. Most investors think selling short is the reverse of going long and the holding period should start on the date you short the security — but that is not the case.

Holding period rules are more complicated when you short against the box. Special anti-abuse rules contained in Section 1233 prevent traders from converting short-term capital gains into long-term capital gains and long-term capital losses into short-term capital losses.

Special Rules in IRS Pub. 550.
“Gains and holding period. If you held the substantially identical property for 1 year or less on the date of the short sale, or if you acquired the substantially identical property after the short sale and by the date of closing the short sale, then:

  • Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain, and
  • Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.

Losses. If, on the date of the short sale, you held substantially identical property for more than 1 year, any loss you realize on the short sale is a long-term capital loss, even if you held the property used to close the sale for 1 year or less. Certain losses on short sales of stock or securities are also subject to wash sale treatment.”

Dividends and “payments in lieu” of dividends
When traders borrow shares to sell short, they receive dividends that belong to the lender, the rightful owner of the shares. After the short seller receives these dividends, the broker uses collateral in the short seller’s account to remit a “payment in lieu of dividend” to the rightful owner to make the lender square in an economic sense. But there are complications which may lead to higher taxes.

Dividend issues for the short seller
If a short seller holds the short position open for 45 days or less, add the payment in lieu of dividend to cost basis of the short sale transaction reported on Form 8949 (realization method) or Form 4797 (Section 475 MTM method). Watch out for a capital loss limitation. (Traders with trader tax status using Section 475 are not concerned as they have ordinary loss treatment.)

If a short seller holds the short sale open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense. Report investment interest expense on Form 4952. Watch out, because the current year tax deduction is limited to net investment income, which includes portfolio income, minus investment expenses. (See Form 4952 instructions.) Carry over disallowed investment interest expense to the subsequent tax year(s). With itemized deduction limitations, some short sellers come up short on investment interest expense deductions. (If a short seller holds the short sale open for more than 45 days, in connection with a trading business with TTS, payments in lieu of dividends are deductible as business expenses.)

Dividend issues for the lender
When investors sign margin account agreements, few realize they are authorizing their broker to lend their shares to short sellers. Instead of issuing the account owner (lender) a Form 1099-DIV, which may include ordinary and qualified dividends, the broker issues a Form 1099-Misc or similar statement for “Other Income.” The lender forgoes the qualified dividends tax break on common stock held at least 60 days. Lower capital gains rates apply on qualified dividends.

Lenders report this substitute dividend payment as “Other Income” on line 21 of Form 1040. Don’t overlook including substitute dividends in investment income entered on Form 4952 used to limit investment interest expense. Some brokers offer to compensate lenders for losing the qualified dividend rate. Institutional or large stock lenders may earn credit interest on lending out their shares.

In my next blog post, I cover how to deduct stock borrow fees.

MORE: IRS Pub. 550 Short Sales

MORE: Section 1.1233-1 – Gains and losses from short sales

MORE: 1259 – Constructive sales treatment for appreciated financial positions


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