The new year symbolizes a restart, a clean slate, the starting line of yet another potential future. The last thing you want is to get stuck dealing with past business that you thought was resolved.
For investors, there are a number of unexpected items that may show up when you file your taxes for the previous year—things like wash sales, constructive sales, closing short positions, index options, substitute payments, and more. But, with a bit of year-end tax planning you might be able to mitigate, or even avoid, any tax bill surprises.
Here are a few year-end tax tips as you wrap up your investment activities for 2017.
If you sell a stock at a loss and then repurchase the same stock 30 calendar days before or after the loss-sale date, your trade is considered a wash sale. The wash sale rule is Uncle Sam’s way of telling you that if you plan on maintaining a stock position, you can’t nab tax deductions as your stock moves down in price. Although the wash sale concept is fairly easy to understand, it’s important to be aware of how this 61-day window may affect trades at the end of one year and the start of the next.
Let’s suppose, come December, that you’ve decided to sell your stock at a loss for tax-deduction purposes. If you close your position, say mid-December 2017, and repurchase the stock in January 2018 before the end of the 30-day window, you’ve technically made a wash sale. This means you can’t deduct your capital loss for that stock from your 2017 taxes after all, as you’ve carried the trade over to 2018. Note that wash sale rules also apply to “short” positions that are closed at a loss.
Suppose you’re long a stock whose price had risen. Next, you hear forecasts indicating that your stock may be in for a downturn. Despite the negative news, you believe your stock is worth keeping for the long run, so you decide to hedge your investment by opening a short position against your long position. You are now long and short the same stock.
This is called “shorting against the box.” It essentially means that you have locked in, or “boxed in,” your current profit by initiating a new short position against the stock you are simultaneously holding. If you own, say, 100 shares of a stock that had risen from $50 to $75, you have an unrealized profit of $25 a share. If you short 100 shares of the same stock while simultaneously holding it, you then create a situation in which any price movement from that point on, up or down, will no longer yield profit or loss. You’ve hedged your entire position.
This has some tax implications. Because neither the long nor the short position has been closed—both are still active—your 1099-B will not show a gain. But technically, you do have a gain: the one you locked in. And that gain is considered a constructive sale.
Although the IRS instructs brokers not to report constructive sales on client 1099s, according to the Taxpayer Relief Act of 1997, taxpayers are required to disclose and pay taxes on capital gains from boxed positions.
Constructive sales can also be triggered by certain option strategies, accounts held among different family members, and various other scenarios. Read the IRS Publication 550 to get a more comprehensive understanding of the rules concerning “constructive ownership of stock.” You may be required to report certain gains excluded from your 1099-B.
Better yet, ask your tax professional for clarification on the rules concerning constructive sales, and whether such an approach might be advisable for your investment practices. And remember that not all account types at TD Ameritrade offer the capability to initiate short-against-the-box positions.
Closing Short Positions
It’s easy to assume that “going short” a stock is like buying low and selling high in reverse. This may be true in principle. But when it comes to the IRS, long and short positions are treated differently.
The main difference is that all short positions, once covered, are considered short-term trades. How does that work? Although your purchase date is the date on which you bought the stock to cover your short position, your sale date is not the date on which you initiated your short position. Instead, it’s the settlement date of your buy to cover; approximately one to two business days from the day you close your position by purchasing the stock.
So if you short a stock in October 2016 and buy to cover a year later on October 2, 2017, your actual sale date occurs after your buy date. It might be any day between October 3 to October 5, 2017—whichever date your purchase settles.
If you plan to close a short position in late December in order to report your profits or losses for the 2017 tax year, note that December 27 is the last day to cover your short position. Take that two-day holding period for settlement into account. If you close your short position on December 28 or 29, your position will settle in 2018, and your profit or loss will appear on your 2018 1099-B.
Suppose you own a portfolio of stocks generating dividend income. If you purchased any of your stocks on margin, you might notice on your year-end tax forms that some of the money you received is listed as payments rather than dividends. And those payments will be taxed at ordinary income tax rates rather than the more favorable dividend rates. They’ll be reported via 1099-MISC rather than 1099-DIV/INT.
Why might you be receiving payments rather than dividends? If you buy a stock in a margin account, your broker can lend your shares to another investor who wants to short the stock. Although you are long, you are no longer on record as the “owner” of that stock if someone else shorts it. If your stock pays dividends, the investor who is short the stock must compensate you by “paying” the amount of the dividends you are entitled to receive (see figure 1). Hence, you are receiving a substitute payment in lieu of the dividend.
In a cash account, the shares you purchase cannot be loaned out to short sellers, so you won't need to worry about substitute payments. In a cash account, your dividends will be dividends.
Now, if you happen to be the short seller, you can deduct your payments (dividend short charges) to the original owner as long as you held your position for at least 46 days. If you closed your position within 45 days or less, you will have to add the amount of your dividend short charge to your buy-to-cover price.
For example, let’s suppose you short stock ABC at $40 a share. ABC pays a dividend of $1, an amount that you end up paying to the original stock owner. A month and a half later, stock ABC trades down to $30 a share and you buy to cover for a $10 profit. Because you held your short position for less than 46 days, you are unable to deduct your $1 payment on an itemized return. Instead, you can ask your broker to increase your cost so that your buy-to-cover price is now $31, for a profit of $9 instead of $10.
Bear in mind that your broker will not increase your basis unless you request it. So if you plan on doing so, be sure to inform your broker right away. It beats having to amend your tax form.
Broad-based index options, categorized as a Section 1256 contract, are taxed at a lower rate of 60/40. This means that 60% of the gains or losses are treated as long-term positions (even day trades!) and 40% are taxable as short-term positions. With a maximum rate of 28% to 12%, index options present a considerable tax savings as compared with the maximum ordinary rate of 39.6% (as of 2017).
Because index options are marked-to-market (MTM) on a daily basis, as is the case with all Section 1256 contracts, both realized and unrealized gains and losses will be reported at the end of the year. Unlike regular securities, whose realized gains and losses are reported on Form 8949, these contracts require a typical investor to file a Form 6781.
Year end tax planning can be a complicated and difficult matter to deal with, especially considering the many demands on your time around the holidays. No; tax planning is not exactly a lot of fun. But you don’t want to make mistakes that might complicate things for the next year come tax time. Perhaps the best advice is to consult a tax professional ... long before the year ends.
Tax Time Ahead
The Tax Resources page is chock full of tax calculators, guides, an archive of relevant content, and a link to IRS and tax forms.