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Traders: Time to Think About Tax-Smart, Year-End Moves

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October 28, 2015
year-end tax moves

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.   

Constructive Sales

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 sells the same shares short, it creates a “box” around the position. 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, taxpayers are still required to come clean and pay the taxes on the capital gains, as directed by the Taxpayer Relief Act of 1997.

This is just a basic example of a constructive sale. 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. 

Closing Your Short Positions

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 2011 for $190. You close out your position on August 10, 2015, at around $525 for a hefty loss. What is your sale date and what is your purchase date? Actually, June 2011 has nothing to do with it! Your purchase date is the trade date of your buy to cover (August 10, 2015) and the sale date is the settlement date of the buy to cover (August 13, 2015). That’s because you must factor in a 1-to-3 day holding period.

The last day to close your short equity positions for 2015 tax reporting is December 28, 2015. If you close your shorts on December 29, 30, or 31, they will settle in 2016 and therefore be reported on your 2016 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 2015.

Wash Sales

The trading you do in January 2016 can actually affect your 2015 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 2015 tax reporting. Then, the trader buys back 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, a purchase in January can take away a loss from December. Read more on wash sale reporting.

Substitute Payments

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 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.

Substitute tax payment

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!

Index Options

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.

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