Short sales against the box after the TRA '97.

• Author: Tucker, Lawrence E.
• Position: Taxation of hedge stock transactions

Prior to the enactment of the Taxpayer Relief Act of 1997 (TRA '97), a taxpayer could hedge against volatility in the value of stock by completing a "short sale against the box," which had no tax consequences until the taxpayer closed the position by returning borrowed shares to the lender. The TRA '97 curtailed use of this technique by deeming the short sale a constructive sale on which gain or loss must be immediately recognized (whether or not the position is sold). This article explains the new law and whether the short sale against the box has survived.

The legislative history and the conference reports for the Taxpayer Relief Act of 1997 (TRA '97) clearly indicate a congressional desire to diminish tax-motivated transactions, such as shorting against the box. In a "short sale against the box," a taxpayer owns a long position and borrows an equal amount of stock from his broker to sell. The taxpayer believes that the stock price will drop in the near future and that the short position can be covered with less expensive shares.

Before the TRA '97, a short sale against the box transaction generally was used to defer capital gains tax on the disposition of a long position. A taxpayer with a significantly appreciated long position would hedge it by selling an equal amount of stock short. The taxpayer would then hold the hedged position until a future tax year, and eventually cover it with the low-basis long position. However, the TRA '97 significantly curtailed the usefulness of this deferral technique; this article discusses these changes and offers planning options.

Background

Prior to the TRA '97, a taxpayer generally did not recognize immediate gain on a short sale against the box. The gain on the borrowed and sold shares was not recognized until the taxpayer closed the sale by returning identical property to the lender. Sec. 1259 was enacted by TRA '97 Section 1001(a). Post-TRA '97 Sec. 1259(a) (1) is relatively straightforward--if a taxpayer makes a "constructive sale" of an "appreciated financial position" (AFP), he recognizes gain as if such position were actually sold, assigned or otherwise terminated at its fair market value (FMV) on the date of such constructive sale. In addition, under Sec. 1259(a)(2), a proper adjustment is made in the amount of any gain or loss subsequently taken into account on that position and a new holding period begins for that position starting on the date of the constructive sale.

Definitions

Sec. 1259(b)(1) defines an AFP generally as any position with respect to stock, a debt instrument or partnership interest if there would be gain on a taxable disposition of the position at its FMV. Other debt instruments, including those...