Selling Short Against the Box
Short-selling securities owned by an investor without completing his long position is known as selling short against the box. Gains on equities are countered by losses, resulting in an investor’s neutral position. According to the IRS, selling short against the box is mostly done to avoid paying taxes.
Historically, investors would hold securities and stock certificates in a safety deposit box. This is where the term “selling short against the box” originates.
In other words, shorting stocks that you already possess without closing out your long position is known as selling short against the box. As a result, all gains in a stock are equal to all losses, resulting in a neutral position. Typically, the goal is to avoid incurring capital gains exposure from a transaction that is about to close. To discourage this, the practice has been regulated by the tax authorities. For example, if you possess 100 shares of AAPL and tell your broker to sell them short, you’ve just completed a short sale against the box. You carry the long position in one account and the short position in another.
Legitimate Scenarios
Going short against the box, or shorting the box, is considered a tax minimization or avoidance strategy. When traders do not want to close out their long position on a stock, they adopt this strategy. Before 1997, no capital gains are realized by selling short in a different account while keeping the long position. Meanwhile, any fresh gains generated by one account will be canceled equally by losses in the other. However, investors might legitimately consider this strategy if they believe a stock they hold is headed for a price drop. In this case, they do not want to sell because they believe the drop will be transitory. After a brief correction period, the stock should rapidly rebound.
Short Sale vs Selling Short Against the Box
Short Sale
A short sale is when a seller sells a stock that he or she does not own or when a sale is completed by the delivery of a stock that the seller has borrowed for the seller’s account. Most short sales are usually closed by the seller delivering a security that he or she has borrowed. Normally, short-sellers often close out their positions by returning the borrowed security to the stock lender and buying securities on the open market. In general, short-sellers usually intend to profit from a downward price movement or to mitigate the risk of a long position in the same or a related security.
Selling Short Against the Box
Selling short against the box is the act of selling short securities that you already own. For example, if you own 100 shares of GOOG and tell your broker to sell short 100 shares of GOOG, you have shorted against the box. Note that when you are short against the box, you have locked in your gain or loss. This is because every dollar the long position gains, the short position will lose and vice versa. As a result, the IRS believes the sole rationale for shorting against the box is to delay a taxable event.
Why People Sell Short Against The Box
When it comes to selling short against the box, the primary reason most investors do it is to reduce their tax exposure for a specific tax year. For example, an investor may have made a short sale on the box because he expects his income to be low in the coming year. He believes that by closing his long position the following year, he will be able to postpone the taxable event. According to the tax laws in effect before 1997, if an investor holds one short and one long position, all long-term capital gains will be temporarily offset by short-term losses. This was the most popular method of delaying tax payments for a year prior to the 1997 regulatory revisions.
However, in 1997, the tax laws were revised to discourage investors from selling short against the box as a tax delaying event. Under TRA97, any gains or losses against the sales are not deferred from tax. Instead, the capital gains of a certain year will be taxable in the same year.
Later on, the SEC and Financial Industry Regulatory Authority(FINRA) also limits when an investor can short sale. For example, a limitation was enacted in 2010. It states that short selling of a specific security will be suspended if a price drop of that security is more than 10% in a single day.
Short Against the Box – Restrictions and Tax Avoidance
Taxpayer Relief Act of 1997 – TRA97
The primary motivation for shorting against the box prior to 1997 was to postpone a taxable occurrence. Owning both long and short positions in a stock, according to tax laws in effect prior to that year, meant that any paper gains from the long position would be temporarily offset by the offsetting short position. Both positions had a net effect of zero, implying that no taxes had to be paid. To discourage this, selling short against the box was no longer allowed as an acceptable tax deferral strategy by the Taxpayer Relief Act of 1997 (TRA97). Capital gains or losses from short selling against the box are not delayed under TRA97. Any corresponding capital gains taxes will be due in the current year, according to the tax implications.
SEC/FINRA Uptick Rule
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) further regulated when sellers are allowed to sell short. The SEC, for example, enacted the alternative uptick rule in February 2010. This suspends short selling when a stock falls more than 10% in a single day. Short sellers (even if the shares are already owned) will almost always need to open a margin account in this case.
Example of Selling Short Against the Box
Consider the following scenario: you have a large paper gain on AAPL shares in your regular brokerage account, which is not a margin account. You believe AAPL has achieved its apex and would like to sell. The capital gain, on the other hand, will be taxed. Perhaps you intend to make significantly less money the next year, putting you in a lower tax bracket. As a result, it’s better to take the profit when you’re at a lower tax rate. So, you short the ABC’s shares in your margin account to lock in your winnings this year. You borrow shares from a broker on the assumption that AAPL’s stock price will rise, as is normal. When your bet pays off, you return to the broker the shares you already held before the short, avoiding the taxable event.
Under TRA97, capital gains or losses incurred from short selling against the box are not deferred. The tax implication is that any related capital gains taxes will be owed in the current year.
Is There a Loophole in TRA97?
The 1997 modifications appear to provide a small loophole that allows shorting against the box to postpone a taxable event. For example, consider an investor who has a short against the box position. Within the first 30 days of a tax year, if he buys in short, leaving his long position at risk for 60 days before closing long, the constructive sales act will not apply. So, there is still the opportunity of selling short against the box but with a risk of exposing yourself for 60 days in every tax year.
If you have a short against the box position and then buy in the short within 30 days of the start of the tax year and leave the long position at risk for at least 60 days before offsetting it again, the constructive sales rules do not apply. So it appears that you can continue shorting against the box to defer gains, but you have to temporarily cover the short and be exposed for at least 60 days at the beginning of each and every year. (Source: invest-faq.com)
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