7525 / When and how is a short sale taxed?

Generally, if a taxpayer holds an appreciated financial position (see Q 7617) that is the same as or substantially identical to the property sold short, the short sale will be treated as a constructive sale of that position, unless certain requirements are met for closing out the short position.¹ Furthermore, if a taxpayer holds a short sale position that has appreciated, the acquisition of the same or substantially identical property (e.g., to cover the short sale) constitutes a constructive sale of the short sale position, which is subject to the same rules.²

Unless certain exceptions apply, a constructive sale results in immediate recognition of gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale.³ For an explanation of the constructive sale rules for appreciated financial positions under IRC Section 1259, see Q 7617 to Q 7621.

A sale of appreciated stock “short against the box” constitutes a constructive sale of an appreciated financial position (see Q 7617 to Q 7621).⁴ (Under earlier law, short sales against the box were taxed as a short sale.)⁵

The nature of capital gain recognized as a result of a constructive sale of an appreciated financial position may be subject to the rules of IRC Section 1233 and regulations thereunder, which generally govern the determination of a taxpayer’s holding period for gain or loss on short sale transactions. (Those rules are described in Q 7526.) The treatment of capital gains and losses is explained in Q 702.

In the case of a short sale that, if terminated, would result in a loss, the taxable event following a short sale does not occur until the seller delivers stock to the lender to “close” the sale, not when the sales agreement was made, nor when the borrowed stock was delivered to the purchaser (see Q 7524).⁶ If the seller’s tax basis exceeds the sale proceeds, the seller will realize a capital loss.⁷

If the seller does not hold the same or substantially identical property, a short sale alone will not result in constructive sale treatment; but at such time as the seller acquires the same or substantially identical property to close the sale, a constructive sale takes place, under the rules described above, if the short position has appreciated.⁸

For the tax treatment of the “premium” paid by the short seller to borrow the stock for delivery to the buyer, see Q 7529. The treatment of capital gain or loss on sales is subject to the rules set forth in Q 702.

Special rules are provided where a taxpayer holds an offsetting short position with respect to qualified small business stock, see Q 7522.

If a short sale is deemed to be part of a conversion transaction, a portion of the gain recognized upon the sale of stock sold short may be treated as ordinary income.⁹ See Q 7615 to Q 7616 for an explanation of conversion transactions and the tax treatment of them.

No deduction is allowed for a loss incurred in a short sale if, within the 61-day period that begins 30 days before the date the short sale was closed and ends 30 days after such date, the short seller entered into a wash sale.¹⁰