7531 / Are there circumstances in which the deduction allowable for expenses incurred in reimbursing the lender of stock in a short sale for cash dividends paid on the borrowed stock may be limited or deferred?

(1)   If the proceeds of the short sale are used to purchase or carry tax-exempt obligations, the deduction may be disallowed under the general rule prohibiting the deduction of interest expense incurred or continued to purchase or carry tax-exempts. (This does not apply if the seller provided cash as collateral for the short sale and does not receive material earnings on such cash.) (See Q 8044, Q 8050.)¹

(2)   If the proceeds of the short sale are used to purchase or carry market discount bonds or short-term obligations, an otherwise allowable deduction of amounts incurred to reimburse the lender of stock for cash dividends may have to be deferred under the rules discussed in Q 8045 and Q 8046.(A short-term obligation is a bond, note, debenture, certificate, or other evidence of indebtedness that has a fixed maturity date not more than one year from the date of issue.)²

(3)   In any event, the amount of the otherwise deductible reimbursement must be treated as an investment interest expense and thus is subject (along with any other investment interest expense) to the general limitation on the deduction of investment interest (see Q 8040).³