7530 / May an investor deduct expenses incurred in reimbursing the lender of stock in a short sale for cash dividends paid on the borrowed stock?

However, if the amount of the cash dividends being reimbursed equals or exceeds 10 percent (5 percent in the case of a short sale of stock that is preferred as to dividends) of the amount realized by the short seller in the short sale, the expenditure must be capitalized (i.e., added to the basis of the stock used to close the short sale) unless the short sale is open for at least 366 days.² For this purpose, all dividends paid on the short sale stock that have ex-dividend dates within the same 85 consecutive day period must be treated as a single dividend.³ (Dividends that equal or exceed the 10 percent (or 5 percent) threshold are referred to as “extraordinary dividends.”)⁴

Assuming the short sale is open for a period of 46 days (366 days in the case of an extraordinary dividend) or more, the amount paid by the short seller to reimburse the lender for cash dividends is usually deductible as an expense incurred in the production of income.⁵ However, when it appears that the sole motive for the short sale was the reduction of income taxes (through the deduction or offset of capital losses), the Service has taken the position that such amounts are not deductible.⁶

If the short seller must report ordinary income as a result of receiving compensation for the use of collateral provided in connection with borrowing stock for the short sale, he or she will generally be permitted to deduct, to the extent of such income, the amounts paid to reimburse the lender for dividends even though the sale was not open more than 45 days. (This exception does not apply in the case of “extraordinary dividends.”)⁷

For purposes of determining whether a short sale has been open for at least 46 (or 366) days, the running of such period must be suspended during any period in which (1) the seller holds, has an option to buy, or is under a contractual obligation to buy, stock or securities that are substantially identical to those sold short, or (2) as set forth in regulations, the seller has diminished his or her risk of loss by holding one or more other positions in substantially similar or related property.⁸ For a discussion of the deductibility of stock dividends and liquidating dividends, see Q 7532.