Get ready for tax-smart trading at year’s end. That means constructive sales, closing short positions, wash sales, substitute payments, index options, & more.
Before we know it, the little guy in the New Year’s diaper will pay us a visit. That means it’s time to start thinking about year-end trading that could impact your tax bill.
There’s a lot to think about when trading at year’s end: constructive sales, closing short positions, wash sales, substitute payments, index options, and more. Let’s dig into a few.
A constructive sale occurs when a trader owns a long position, but then shorts against “the box” at a higher price than the basis of the long position.
What’s that about a box? When a trader holds shares long but also holds the same shares short, the position is called "short against the box." The trader essentially locks in a gain, but there are no broker-reportable tax implications. Because the long position hasn’t been sold and the short position hasn’t been covered, a 1099-B will not show any record of the gain.
The IRS has explicitly declared that brokers are not to report constructive sales on client 1099s. However, as directed by the Taxpayer Relief Act of 1997, taxpayers are still required to come clean and pay the taxes on the capital gains the year the box was created. If there is a gain, the taxpayer should report the year the box was created. If there is a loss, the year it is flattened. Not all account types are eligible for boxed positions, so it is possible that some accounts could automatically flatten the position.
This is just a basic example of a constructive sale. Certain option strategies can also trigger constructive sales of appreciated positions. There are other things to consider, such as another rule covering “constructive ownership of stock.” This includes constructive sales among the accounts of different family members and many other scenarios. In such cases, the trader may be required to report a gain that the broker can’t, as outlined in the 1099-B instructions.
Ask your tax professional for clarification on whether constructive sales make sense for your investing approach. And remember, this only applies to boxed positions on which you have a gain. Keep in mind, a short against the box position may not be available for all account types at TD Ameritrade.
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 short-term capital gain is for the 2015 tax year.
Source: Excerpt from IRS Publication 550 for 2015; no rule change is expected for 2016 filing year. For illustrative purposes only.
Why is it that when you close a short position it results in a short-term gain or loss? Well, let’s say you sold stock XYZ short in June 2012 for $190. You close out your position on August 8, 2016, at around $525 for a hefty loss. What is your sale date and what is your purchase date? Actually, June 2012 has nothing to do with it! Your purchase date is the trade date of your buy to cover (August 8, 2016) and the sale date is the settlement date of the buy to cover (August 11, 2016). That’s because you must factor in a 1-to-3 day holding period.
The last day to close your short equity positions for 2016 tax reporting is December 27, 2016. If you close your shorts on December 28, 29, or 30, they will settle in 2017 and therefore be reported on your 2017 1099-B. Long positions are reportable based on the trade date of the sale, whereas short positions are reportable based on the settlement date of the buy to cover. If you wait until the last trading day of the year to close your short positions, you may be in for a surprise if you want this reported in 2016.
The trading you do in January 2017 can actually affect your 2016 tax reporting as part of a wash sale. Let’s say a trader didn’t make any purchases in December and closed out of a position in time for 2016 tax reporting. Then, the trader buys the same security in January. Remember, the 61-day window is 30 days before and after the sale at a loss, including the day of the sale. Thus, the purchase in January can take away a loss from December. Read more on wash sale reporting. Wash sales can apply in both long and short transactions sold at a loss.
Let’s say you are bullish and purchase a stock on margin. You’re now holding a debit balance. The margin agreement has a section detailing the circumstances that will allow your broker to loan out your shares to short sellers (aka rehypothecation). Up to 140% of your balance owed can be loaned out in the form of shares held in your account. If time goes by and your stock is eventually loaned out, the security makes a dividend distribution. Even though you’re long the shares, you’re not on record as the owner. Instead of receiving the money from the security, you’re receiving the funds from the person who sold your shares short. Take a look at figure 1.
FIGURE 1: OWNERSHIP ILLUSTRATED. This diagram helps explain the substitute payment tax rule that applies to some traders using margin. For illustrative purposes only.
What does all this have to do with taxes? As the original owner, you’ll receive a substitute payment instead of the dividend/interest income. Instead of 1099-DIV/INT reporting, you will be receiving a 1099-MISC reporting your substitute payments. Now, if you were the person who sold short, you may be able to deduct the payments you had to pay the original owner (dividend short charges), assuming you held the short position for at least 46 days when you itemize your deductions. If you held your short position for 45 days or less, you must increase the basis of your buy to cover by the amount of the dividend short charge.
Here’s an example. Suppose you short stock XYZ at $50 a share. XYZ pays out a $1 dividend (which you owe the person whose shares you borrowed). The stock falls to $35 and you close your short position 40 days after shorting. Instead of taking the $1 as a deductible expense (on an itemized return), you are supposed to inform your broker that your cost should be increased. Your purchase price will now be $36 with a sale price of $50. You will have a $14 gain instead of $15.
This adjustment is not done automatically by a broker; it must be requested by the taxpayer. So review your activity at the end of the year, and if you need to tell your broker to increase your basis, do so as soon as possible so that you don’t have to wait for a corrected tax form. Go ahead, read this section again—it’s a lot to take in!
Narrow-based index options are reported for tax purposes just like equity options. However, Section 1256 contracts are unique. First off, there is the 60/40 rule. With this IRS rule, 60% of the gain/loss is treated as long-term and the remaining 40% is taxable as short-term, regardless of how long your position is actually held. This can make quite a difference if you are comparing the max tax rates of up to 39.6%! Also, these contracts are treated as closed at year-end whether you have settled the position or not (also known as mark-to-market). There is no 8949 reporting to be done, either. Instead, you should be filing a Form 6781 to the IRS for these contracts.
Few people really want to think about taxes every day of the year. But you also don’t want to make a mistake at year-end. Let’s face it, taxes are difficult. Your best move may be to get your tax professional involved long before the calendar flips.
This article is an update of the original Traders: Time to Think About Tax-Smart, Year-End Moves published on October 28, 2015.
Check out this video on tax-efficient investing. You can also give us a call at 800-669-3900; Client Services is available 24/7. To speak with a Tax Services Representative, call Monday through Friday, from 9 a.m. to 5:30 p.m. ET.
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