Short Sales and the Wash Sale Rule

The wash sale rule prevents you from deducting a loss from selling stock if you acquire replacement stock shortly before or after the sale. The rule here is so confusing that even the IRS seems to get mixed up in Publication 550.

Background

When you sell short, you borrow stock from an unknown person’s account and sell it in the market. You have an obligation to return identical shares to the account from which you borrowed the shares. You can fulfill that obligation by delivering shares you already own at the time of the short sale, or by purchasing shares in the stock market.

The general rule for short sales for many years has been that you don’t report gain or loss until you close your position by delivering stock. It’s only then that you can determine whether you had a gain or a loss on the transaction. That was true even if you sold shares identical to shares you already owned — or to use stock market lingo, sold short against the box.

Recently the law changed so that if you sell short against the box, you can be treated as if you sold the stock you already owned. This rule applies only if a sale of your stock would produce a gain and certain other things are true. When these constructive sale rules apply, you have a gain at the time you make the short sale, so we’re obviously not talking about deducting losses. In the discussion that follows, we assume at all times that the constructive sale rules don’t apply to the short sale.

Full coverage of the constructive sale rule appears in Capital Gains, Minimal Taxes.

Two Different Questions

Most of the difficulty surrounding the application of the wash sale rule to a short sale stems from a failure to recognize that it involves two different questions:

• Under what circumstances will a replacement purchase of stock cause a short sale to be a wash sale?
• Under what circumstances will an additional sale of stock cause a short sale to be a wash sale?

We have these two different questions because a short sale can be used in two different ways. First, it can be a funky way to sell stock you already own. If you end up with a loss, you lost money because the price of the stock went down while you held that stock. In this case a replacement purchase would produce a wash sale.

A short sale can also be a way of taking a negative, or bearish, position on a stock. If you lose money from a short sale that’s closed with stock you didn’t own at the time of the wash sale, it’s because the price of the stock went up while you were short. Just the opposite of the previous case! In this situation, you should get a wash sale when you make an additional sale of stock within the wash sale period.

Buying Replacement Stock

Suppose you bought 100 shares of XYZ at $80 only to see its price plummet to $30. You want to report a loss on your tax return, but you feel the stock is poised for a rebound so you don’t want to part with it. You come up with the following scheme.

First, you enter into two simultaneous transactions. You buy another 100 shares of XYZ at $30, and you sell short 100 shares of XYZ, also at $30. Overall your position hasn’t changed: instead of simply owning 100 shares, you hold 200 shares and have an obligation to deliver 100 on the short sale. You wait 31 days, then close the short sale with your original shares.

The overall result? You’ve never changed your position in the stock. You started out owning 100 shares and ended up owning 100 shares. In between you owned 200 shares and you were short 100. But now the old shares are gone and you have other shares in their place. It’s clear that the wash sale rule should apply.

And, in fact, the regulations confirm this. They say you use the date you entered into the short sale, not the date you closed the short sale, to measure the wash sale period if you close the short sale by delivering stock you owned at the time of the short sale. In the transaction described above, you bought replacement stock at the same time you made the short sale, so the wash sale rule applies.

What if you close the short sale at a loss using stock you didn’t own at the time you entered into the short sale? The regulation implies that you would have a wash sale if you bought replacement stock within 30 days of the date you closed the short sale. This doesn’t make any sense, because your loss in this case results from a short position, not from a long position. You’re not replacing the position that produced the loss if you buy more shares within 30 days of closing the short sale. Nevertheless, it’s possible the IRS would take the position that the wash sale applies in this situation.

Making Another Sale

Suppose you’re expecting a stock to go down, and you decide to sell it short without owning any shares. You have an overall short position in the stock. To your chagrin, the stock’s price rises, so you’re holding a losing short position. You still expect the stock to fall, so you want to remain short on this stock. What happens if you buy stock to close the short position, then immediately establish a new short position?

That’s just the mirror image of a classic wash sale. Curiously, although the wash sale rule harks back to the 1920s, this particular transaction wasn’t covered until 1988. Still more curiously, the Treasury hasn’t seen fit to provide regulations explaining how this “new” rule works, all these years later.

There’s no question the rule applies in the situation described above. In fact, it appears to apply any time you close a short sale at a loss and, within the wash sale period, either enter into a new short sale or even simply sell additional shares you already owned.

There’s one situation where it shouldn’t apply. It’s the flip side of the situation described earlier for new purchases. If you close a short sale at a loss by delivering shares you held at the time you entered into the short sale, your loss was incurred on the long position, not on the short position. It shouldn’t matter if you make another sale (short sale or regular sale) within 30 days of closing the short sale. But the law appears to treat this situation as a wash sale.