7527 / How is a short sale taxed when the property sold becomes substantially worthless?

Under provisions predating the constructive sale rules (see Q 7617 to Q 7621) to prevent individuals from using short sales to convert short-term gains to long-term gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, the IRC and regulations provide special rules as follows:

(1) If on the date the short sale is closed, any “substantially identical property” (see Q 7528) has been held by the seller for a period of one year or less, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.² This is true even though the stock actually used to close the short sale has been held by the seller for more than one year. This rule does not apply to losses realized on the property used to close the sale.

(2) If any substantially identical property is acquired by the seller after the short sale and on or before the date the sale is closed, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.³ This is true regardless of how long the substantially identical property has been held, how long the stock used to close the short sale has been held, and how much time has elapsed between the short sale and the date the sale is closed. This rule does not apply to losses realized on the property used to close the sale.

(3) The holding period of any substantially identical property held one year or less, or acquired after the short sale and on or before the date the short sale is closed will, to the extent of the quantity of stock sold short, be deemed to have begun on the date the sale is closed or the date such property is sold or otherwise disposed of, whichever is earlier. If the quantity of such substantially identical property held for one year or less or so acquired exceeds the quantity of stock sold short, the “renewed” holding period will normally be applied to individual units of such property in the order in which they were acquired (beginning with earliest acquisition), but only to so much of the property as does not exceed the quantity sold short. Any excess retains its original holding period.⁴ However, where the short sale is entered into as part of an arbitrage operation in stocks or securities (see Q 7533), this order of application is altered so that the “renewed” holding period will be applied first to substantially identical property acquired for arbitrage operations and held at the close of business on the day of the short sale and then in the order of acquisition as described in the previous sentence. The holding period of substantially identical property not acquired for arbitrage operations will be affected only to the extent that the quantity sold short exceeds the amount of substantially identical property acquired for arbitrage operations.⁵

If substantially identical property acquired for arbitrage operations is disposed of without closing the short sale, see Q 7534.

(4) If on the date of a short sale any substantially identical property has been held by the seller for more than one year, any loss realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be long-term capital loss.⁶ This is true even though the stock actually used to close the short sale has been held by the seller for a year or less. This rule does not apply to gains realized on the property used to close
the sale.

Capital gain or loss from the sale or exchange of a securities futures contract—see Q 7586—to sell property (i.e., the short side of a futures contract) will generally be short-term capital gain or loss unless the position is part of a straddle, see Q 7599. In other words, a securities futures contract to sell property is treated as equivalent to a short sale of the underlying property.⁷

See Q 7528 and Q 7539 for a discussion of what constitutes substantially identical property for purposes of these rules.