Sale Or Exchange

<div class="Section1">No special tax rules apply if an investor realizes a <em>gain</em> in a wash sale of stock or other securities; rather, the sale will be taxed under the rules peculiar to both the type of disposition and to the particular stock or security sold. For the taxation of gain on treasury bills, bonds and notes, and municipal bonds, <em><em>see</em></em> respectively Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7626">7626</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7632">7632</a>, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7663">7663</a>. For taxation of gain on corporate obligations, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7628">7628</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7635">7635</a>. For taxation of stock, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7517">7517</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7522">7522</a>.<div class="Section1"><br /> <br /> On the other hand, to the extent that shares of stock or securities sold are replaced in a wash sale (as defined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7536">7536</a>), any <em>loss</em> realized on the stock or securities sold may <em>not</em> be recognized for income tax purposes and, therefore, may not be used to offset capital gains or otherwise deducted. However, if the quantity of the stock or securities sold at a loss exceeds the quantity replaced, the loss realized on the excess shares or securities may be recognized as a capital loss for income tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1091(b);&nbsp;Treas. Reg. &sect;&nbsp;1.1091-1(c); Rev. Rul. 70-231, 1970-1 CB 171.<br /> <br /> </div></div><br />

<div class="Section1">Whether stock or securities are substantially identical depends on the facts and circumstances of each case.<a href="#_ftn1" name="_ftnref1">¹</a> Beyond that, unfortunately, the IRC and the regulations offer little guidance as to when stock or securities are substantially identical, but it is clear that &ldquo;something less than precise correspondence will suffice.&rdquo;<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> Ordinarily, shares or securities of one corporation are not substantially identical to shares or securities of another corporation. However, a different result may occur as, for example, in reorganization, where facts and circumstances indicate that the stock and securities of predecessor and successor corporations are substantially identical.<a href="#_ftn3" name="_ftnref3">³</a> Where voting trust certificates eventually could be exchanged for common stock held by the trust, the certificates were held to be substantially identical to the common stock of the same corporation.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> When preferred stock is convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make the preferred and common stock substantially identical.<a href="#_ftn5" name="_ftnref5">⁵</a> Also, when a sale of a stock warrant is followed within 30 days by a purchase of stock of the same corporation, the warrant and the newly acquired stock are substantially identical only if the relative values and price changes are similar.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> For purposes of the wash sale rules, options to buy stock or securities apparently can be considered substantially identical not only to the underlying stock, but also to other options or contracts to buy stock or securities.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Under the wash sale rules, a contract or option to acquire or sell stock or securities will include options and contracts that are (or may be) settled in cash or property other than the stock or securities to which the contract relates.<a href="#_ftn8" name="_ftnref8">⁸</a>&nbsp;Thus, for example, the acquisition within the period set forth in IRC Section&nbsp;1091 of a <em>securities futures contract</em> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7586">7586</a>) to acquire stock of a corporation could cause the taxpayer&rsquo;s loss on the sale of stock in that corporation to be disallowed under the wash sale rules, notwithstanding that the contract may be settled in<br /> cash.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Generally, <em>bonds</em> are substantially identical if they are not substantially different in any material feature and are not substantially different in several material features considered together (each of which, if considered alone, would not be regarded as substantial).<a href="#_ftn10" name="_ftnref10">¹⁰</a> Although very few concrete criteria exist to aid in determining which features are material and when such material features alone or in conjunction will result in a substantial difference, the following may be of<br /> guidance:<br /> <ol><br /> <li>The interest rate of a bond is considered a material feature.<a href="#_ftn11" name="_ftnref11">¹¹</a></li><br /> <li>In determining whether bonds purchased are substantially identical to bonds sold, the bonds purchased must be compared as they existed when purchased with the bonds sold as they existed when sold.<a href="#_ftn12" name="_ftnref12">¹²</a></li><br /> <li>Issue dates of bonds are not material features unless some material features are dependent on such dates.<a href="#_ftn13" name="_ftnref13">¹³</a></li><br /> <li>Whether a difference in maturity dates is substantial or not is directly affected by the total time period to maturity (i.e., six months added to the duration of one year is vital; added to a duration of 20 years is negligible).<a href="#_ftn14" name="_ftnref14">¹⁴</a></li><br /> </ol><br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1233-1(d)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; <em>Hanlin v. Comm.</em>, 108 F.2d 429 (3d Cir. 1939).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1233-1(d)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; <em><em>See</em> Kidder v. Comm.</em>, 30 BTA 59 (1934).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1233-1(d)(1); Rev. Rul. 77-201, 1977-1 CB 250.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; GCM 39036 (9-22-83).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1091(a).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp; H.R. Conf. Rep. No.&nbsp;106-1033 (CRTRA 2000).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp; H.R. Conf. Rep. No.&nbsp;106-1033 (CRTRA 2000). <em><em>See</em></em> IRC &sect;&nbsp;1091(f).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; Rev. Rul. 58-211, 1958-1 CB 529.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp;&nbsp; Rev. Rul. 60-195, 1960-1 CB 300.<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp;&nbsp; Rev. Rul. 58-211, 1958-1 CB 529.<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp;&nbsp; Rev. Rul. 58-210, 1958-1 CB 523.<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.&nbsp;&nbsp; <em>Hanlin v. Comm.</em>, 108 F.2d 429 (3rd Cir. 1939).<br /> <br /> </div></div><br />

<div class="Section1">As part of a scheme to postpone the recognition of an economic wash sale loss, rather than disallow it permanently, the IRC provides that both the tax basis and holding period of the replacement stock or securities are to be adjusted. Specifically, the tax basis of the replacement stock or securities is deemed to be equal to the tax basis of the stock or securities disposed of in the wash sale, increased or decreased, as the case may be, by the difference (if any) between the price at which the property was acquired and the price at which the substantially identical stock or securities were sold or otherwise disposed of. This generally has the effect of adding the amount of the unrecognized loss to the cost basis of the replacement stock or securities.<a href="#_ftn1" name="_ftnref1">¹</a> The loss is therefore deferred, not eliminated forever. It can be recognized when the stock or securities are sold or exchanged in a transaction that is not a wash sale.</div><br /> <div class="Section1"><br /> <br /> Where a taxpayer sold stock or securities for a loss and acquired substantially identical stock or securities within a traditional IRA or Roth IRA within the 61-day period, the IRS found a wash sale had occurred. In this case, the taxpayer's basis in the traditional IRA or Roth IRA was not increased by virtue of IRC Section 1091(d). <a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Furthermore, the investor's holding period in the stock or securities disposed of in the wash sale is "tacked" (i.e., added) onto the holding period in the replacement stock or securities.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Where identical quantities of stock or securities are sold and replaced in a wash sale, there is little problem in applying the rules discussed above. But where unequal quantities are sold and replaced or where sales and/or replacements are made in multiple lots (or transactions), the stock or securities sold and the replacement stock or securities must be matched on a chronological basis (beginning with the earliest loss and earliest replacement) before the rules can be properly applied.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <blockquote><em>Example:</em> On March 1, Ms. Whalen sells 1000 shares of X stock (lot A) at a loss of $10,000 and a second lot of 1000 (lot B) on March 2 at a loss of $25,000. On March 10, Ms. Whalen purchases 1000 shares of X stock (lot C). This purchase will result in the nonrecognition for income tax purposes of the $10,000 loss on lot A and an increase of $10,000 in the tax basis of the replacement stock (lot C). In addition, the holding period of lot C will include the holding period of lot A (i.e., the holding period of lot A will be "tacked" onto the holding period of lot C).<br /> <br /> If, on March 20, Ms. Whalen purchases another lot (lot D) of 1000 shares of stock X, the $25,000 loss on the sale of lot B will not be recognized for income tax purposes. The tax basis of lot D will be increased by $25,000, and the holding period of lot B will be tacked onto the holding period of lot D.</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1091(d); Treas. Reg. § 1.1091-2.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   Rev. Rul. 2008-5, 2008-1 CB 271.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1223(4).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.   IRC §§ 1091(b), 1091(c); Treas. Reg. § 1.1091-1.<br /> <br /> </div>

<div class="Section1">The premium paid by an investor to borrow the stock delivered to the buyer in a short sale is an expense incurred for the production of income.<a href="#_ftn1" name="_ftnref1">¹</a> But the amount is generally treated as interest expense (subject to the limitation on the deduction of investment interest).<a href="#_ftn2" name="_ftnref2">²</a> As a result, a short seller may find that only a portion (or none) of the premium is deductible for income tax purposes.<a href="#_ftn3" name="_ftnref3">³</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a> regarding the deduction of investment interest.<div class="Section1"><br /> <br /> Furthermore, if the proceeds of a short sale are used to purchase or carry tax-exempt obligations, the amount of the premium is treated as interest for purposes of the general rule that prohibits the deduction of interest expense incurred or continued to purchase or carry tax-exempt obligations. (But this does not apply if the short seller provided cash as collateral for the short sale and does not receive material earnings on such cash.)<a href="#_ftn4" name="_ftnref4">⁴</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8050">8050</a> for an explanation of this rule.<br /> <br /> If the proceeds of a short sale are used to purchase or carry short-term obligations or market discount bonds, an otherwise allowable deduction of the short sale premium may have to be deferred under the rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8045">8045</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>.(A short-term obligation is one which has a fixed maturity date not more than one year from the date of issue.)<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Rev. Rul. 72-521, 1972-2 CB 128.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; It is not, however, a miscellaneous itemized deduction subject to the limitations of IRC Section&nbsp;67. IRC &sect;&nbsp;67(b)(8).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;163(d).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; IRC &sect;&sect;&nbsp;265(a)(2), 265(a)(5).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; IRC &sect;&sect;&nbsp;1277, 1282, 1283.<br /> <br /> </div></div><br />

<div class="Section1">Even though an amount is deductible under the foregoing rules, a short seller may still find that the deduction is limited or must be deferred as follows:<br /> <blockquote>(1)&nbsp;&nbsp; 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.) (<em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8050">8050</a>.)<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> (2)&nbsp;&nbsp; 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8045">8045</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8046">8046</a>.(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.)<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> (3)&nbsp;&nbsp; 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 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8040">8040</a>).<a href="#_ftn3" name="_ftnref3">³</a></blockquote><br /> The amount received by the lender of stock as a reimbursement for a cash dividend from the borrower is <em>not</em> a dividend,<a href="#_ftn4" name="_ftnref4">⁴</a> and it is therefore not eligible for the preferential treatment applicable to qualified dividends. It is simply ordinary income.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;265(a)(5).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&sect;&nbsp;1277, 1282, 1283.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;163(d)(3)(C).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Rev. Rul. 60-177, 1960-1 CB 9.<br /> <br /> </div></div><br />

<div class="Section1">&ldquo;Arbitrage operations&rdquo; are transactions involving the purchase and sale of stock or securities (or the right to acquire stock or securities) entered into for the purpose of profiting from a current difference between the price of the property purchased and the price of the property sold.&nbsp;The property purchased must either be identical to the property sold (e.g., stock X trading for different prices on different exchanges) or must entitle the owner to acquire property that is identical to the property sold (e.g., bonds convertible into stock X).&nbsp;To qualify as an arbitrage operation for purposes of the short sale rules, the taxpayer <em>must</em> properly identify the transaction as an arbitrage operation on the taxpayer&rsquo;s records as soon as the taxpayer is able to do so; ordinarily, this must be done on the day of the transaction. Only property properly identified as such will be treated as property acquired for arbitrage operations.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> Property that has been properly identified as acquired for arbitrage operations will continue to be treated as such even though, because of subsequent events, the taxpayer sells the property outright rather than using it to complete the arbitrage operation.<a href="#_ftn2" name="_ftnref2">²</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7534">7534</a> as to the effects of disposing of such property without closing a short sale that was entered into as part of the arbitrage operation.<br /> <br /> It is unclear whether an arbitrage operation may be subject to treatment as a conversion transaction (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a>) or whether it may constitute a constructive sale of an appreciated financial position (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1233(f);&nbsp;Treas. Reg. &sect;&nbsp;1.1233-1(f)(3).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1233-1(f)(3).<br /> <br /> </div></div><br />

<div class="Section1">If the short sale constitutes a constructive sale of an appreciated financial position, it will be subject to special rules explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>.Otherwise, a short sale closed by a seller&rsquo;s estate will be taxed under the earlier rules for short sales (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7525">7525</a>). But for purposes of determining gain or loss, if the sale is closed with stock owned by the seller at death, the tax basis in that stock will be its value for federal estate tax purposes &ndash; generally, fair market value on the date of the seller&rsquo;s death.<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> It was determined (under a ruling pre-dating the constructive sales rules of IRC Section&nbsp;1259) that where a trust established by a seller closed a short sale after the death of the seller with stock it held for the seller&rsquo;s benefit, the basis of such stock generally would be its fair market value either on the date of the seller&rsquo;s death or on an alternative valuation date determined under IRC Section&nbsp;2032.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> For short sales that are not subject to the constructive sales rules of IRC Section&nbsp;1259 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7525">7525</a>), the taxable event of the short sale occurred when the estate or trust &ldquo;closed&rdquo; the sale.<a href="#_ftn3" name="_ftnref3">³</a>&nbsp;Thus, any gain recognized on the short sale would <em>not</em> constitute &ldquo;income in respect of a decedent&rdquo; (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="747">747</a>). Special rules may apply to decedents who held an open short sale position within three years of death (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>).<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Rev. Rul. 73-524, 1973-2 CB 307.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Let. Rul. 9319005.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; Rev. Rul. 73-524 and Let. Rul. 9319005.<br /> <br /> </div></div><br />

<div class="Section1">In the case of stock and securities, &ldquo;substantially identical property,&rdquo; for purposes of the short sale rules, has the meaning given to &ldquo;substantially identical stock or securities&rdquo; for purposes of the wash sale rule.<a href="#_ftn1" name="_ftnref1">¹</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a> for details. It would appear that the same definition should apply for purposes of constructive sales of appreciated financial positions under IRC Section&nbsp;1259.<div class="Section1"><br /> <br /> A <em>securities futures contract</em> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7586">7586</a>) to acquire substantially identical property will be treated as substantially identical property.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In addition, for purposes of short sales entered into as part of an <em>arbitrage operation</em> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7533">7533</a>), a taxpayer will be deemed to hold substantially identical property for arbitrage operations at the close of any business day if he or she owns any other property acquired for arbitrage operations (whether or not substantially identical) or has entered any contract in an arbitrage operation which in either case, at the close of that day, gives the taxpayer the right to receive or acquire substantially identical property.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.1233-1(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1233(e)(2)(D).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1233(f)(3);&nbsp;Treas. Reg. &sect;&nbsp;1.1233-1(f)(2).<br /> <br /> </div></div><br />

<div class="Section1">The answer generally depends on the period the short sale is open. If a short sale is held open less than 46 days, any amount paid by the short seller to reimburse the lender of stock for <em>cash</em> dividends paid on the borrowed stock during the period of the loan will not be deductible by the seller. Instead, the seller will be required to add such amount to the tax basis in the stock used to close the short sale (i.e., the short seller will be required to capitalize the expenditure).<a href="#_ftn1" name="_ftnref1">¹</a><div class="Section1"><br /> <br /> 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) <em>unless</em> the short sale is open for at least 366 days.<a href="#_ftn2" name="_ftnref2">²</a> 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.<a href="#_ftn3" name="_ftnref3">³</a> (Dividends that equal or exceed the 10 percent (or 5 percent) threshold are referred to as &ldquo;extraordinary dividends.&rdquo;)<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> 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.<a href="#_ftn5" name="_ftnref5">⁵</a> 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.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> 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 &ldquo;extraordinary dividends.&rdquo;)<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> 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.<a href="#_ftn8" name="_ftnref8">⁸</a> For a discussion of the deductibility of stock dividends and liquidating dividends, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7532">7532</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;263(h)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&sect;&nbsp;263(h)(2), (3), 1059(c)(1), (2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;1059(c)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; IRC &sect;&nbsp;263(h)(2), (3).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Rev. Rul. 72-521, 1972-2 CB 128.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; <em><em>See Hart v. Comm.</em></em>, 338 F.2d 410 (2d Cir. 1964), agreeing with the Service.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; IRC &sect;&nbsp;263(h)(5).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp; IRC &sect;&nbsp;263(h)(4).<br /> <br /> </div></div><br />

<div class="Section1">The cost of purchasing additional shares of stock to reimburse the lender for nontaxable stock dividends and any amount paid to reimburse the lender for a liquidating dividend are always capital expenditures and not tax deductible.<a href="#_ftn1" name="_ftnref1">¹</a> As such, these amounts should be added to the investor's basis in the stock used to close the short sale.</div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 72-521, 1972-2 CB 128.<br /> <br /> </div>