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For years, the "selling short against the box" technique allowed you to lock-in capital gains you currently have, but report them in the subsequent year. It was a frequent practice in December up until the late 1990s. There are still ways to make this work, however. With the currently widely divergent outlooks for 2010 and such strong market gains in 2009, many investors may be interested in selling short against the box. Some risks are involved, however.
The technique was once very simple, and was widely practiced from the 1920s through the 1990s.
This technique was eliminated in 1997 with the introduction of "constructive sale" rules. These rules deemed that in the above situation, the sale of the long position is deemed to have occurred on the day the short position was opened.
In 1997, the tax rules for shorting against the box were strengthened. The primary objective of the rules, however, was to prevent unlimited lock-in of gains. The estate of Estee Lauder, the cosmetic queen, used shorting against the box to secure high values of the stock until her death in 1995. After her death, the short position was closed, and the capital gains were realized, but because the basis of the stock was in an estate, the sale produced no capital gains. The $150 million transfer of wealth without capital gains through the use of this technique prompted Congress to write rules against it.
The use of the shorting against the box technique to postpone tax reconciliation forever has been effectively eliminated.
However, for locking in profits now, and a possible short-term postponing of taxable profits until the subsequent tax year, there are ways to use the shorting against the box technique.
To avoid the constructive sale rules, you need to follow all three of these conditions:
IRS Publication 550 contains the full definition for these rules.
Here are the steps to use this technique today.
The timing of this sequence looks like this:
|December||You sell short an equal number of shares of the position you want to protect.||From this point on, movement in the stock is neutral to your position, although a decline in the stock will shift some long term gains to short term status.|
|Before Jan. 30||Close the short position.||Any gains from the short sale are short-term gains. Losses are actually preferred as they could be used against other short-term losses.|
|At time of closing short position||Make decision.||If you feel that the stock will decline from here on, sell the original long position. The taxable gain must be recorded as if it occurred in December.|
|If you feel that the original long position stock will rise from this point, hold the stock. If you are able to hold for 60 days, the gain will be recorded on the date of the actual sale.|
|Before 60 days are over||Do not open any offsetting transaction.||Any additional offsetting transaction, such as another short sale, resets the 60-day clock.|
|Before 60 days are over||Set stop loss order||If you decide to hold the long position after closing the short position, in hopes of further gains, you should make a decision as to how much risk you take. You can set a stop loss order at that level. If it is invoked, you will book the sale as if it occurred the tax you opened the short position.|
Note that if you open any "offsetting" transaction against the original long position, such as selling put options or opening an additional short position, before the 60 day "naked holding" period ends, you must hold the long position for an additional 60-day period after the new short position is opened.
Range of Possible Scenarios
The range of possibilities for using the short sale against the box technique are detailed in the following table, assuming that you make a short sale in December, with the intent of protecting against a decline in January or February and selling the stock in March or April, whenever 61 days after the short position is closed.
|Time||Stock Rises||Stock Falls|
|December - open short position||No net effect||No net effect|
|January - close short before Jan. 30||Loss on short position||Gain on short position|
|February - sell long position||Gain on long position is taxed as if it occurred in December||Gain/loss on long position is taxed as if it occurred in December|
|March - April (60 days after close of short position)||Gain on long position is taxed on actual day of sale||Gain/loss on long position is taxed as if it occurred in December|
Note that you can win both ways if the following happens: the stock declines in December and January, giving you a gain on the short position, but then rises for 60+ days after the close of the short position. In this scenario, you get the insurance of locked-in-gains you wanted, plus you get to postpone the tax until the subsequent year.
The middle ground is you get the locked-in gains you wanted, but you wind up having to book them in this tax year.
Losing both ways occurs if the stock rises during December and January, then falls through February-April. In this scenario, you lose on the short position when you close it in January, then lose again when the stock falls in March and April. To minimize the risk in this scenario, you can set stop loss orders after closing the short position at a price level with which you are comfortable.
Shorting against the box today is still possible, but it involves some risk.
If you want to avoid risk entirely, and lock in all of your gains on a stock, sell now and pay taxes in this year.
If you want to lock in your profits and take a chance at postponing the tax date, you can use the short sale against the box technique.
At a minimum you can lock in the gains you want until at least Jan. 29, with only the risk of shifting some gains from long-term status to short term status. At best, you can lock in the gains through January, have a gain on the short position, and then have additional gains on the stock from February to April and postpone the tax recognition date.
In any scenario, when you are thinking about selling now to capture a gain, you can at least postpone the decision until near the end of January as to when you want to recognize the gain. If at the end of January, you think that the stock could continue to rise, you may want to go for an additional 60-day holding period. If not, you can close both positions -- and have effectively the same results as if you sold outright now.
Consultation with your tax attorney is recommended if you decide to go this route. Things get more complicated quickly, particularly if you are subject to the alternative minimum tax or have other tax considerations.
There is an additional risk not detailed in the descriptions above.
If long-term capital gains taxes are increased in 2010, the advantages of the complicated "shorting against the box" technique might be entirely negated.
Of course, there is no way to quantify this particular risk.
--Robert V. Green, Senior Investment Strategist