Short Selling

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.)

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…(details in the guide.)

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 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 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 (TTS) using Section 475 are not concerned as they have ordinary loss treatment. If the position is held open for more than 45 days, payments in lieu of dividends are deductible as investment interest expense (reported on Form 4952). Watch out, because the current year tax deduction is limited to net investment income, which includes portfolio income, minus certain investment expenses including stock borrow fees, but not other investment expenses suspended as itemized deductions in TCJA. (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 sale open for more than 45 days in connection with a TTS business, 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 2018 Schedule 1 (Form 1040) line 21. 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. Substitute dividend income is included in net investment income for the ACA net investment tax.

Stock borrow fees and loan premiums

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: Many brokers refer to stock borrow fees as “interest expense,” which confuses short sellers.

For investors, stock borrow fees are “other itemized deductions” on line 16 of the 2018 Schedule A (Itemized Deductions). For 2017 tax returns, stock borrow fees were reported as “other miscellaneous deductions” on line 28 of Schedule A. Instructions for 2017 Schedule A line 28 are the same as 2018 Schedule A line 16 — they include the same items including stock borrow fees. TCJA did not suspend these deductions, whereas, TCJA suspended investment fees and investment expenses (i.e., trading expenses without TTS).

With TTS, stock borrow fees are considered Section 162 business expenses. Stock borrow fees are not “interest expense” so investors can’t include them in “investment interest expense” deductions. Stock borrow fees are deductible for net investment income for ACA’s net investment tax.

Excerpt from Green’s 2019 Trader Tax Guide Chapter 16 Short Selling.