Investors engage in a short sale of stock in an effort to profit from an expected decrease in the value of the stock. A short sale involves borrowing stock, typically one of the services offered via your brokerage account, and selling it immediately. You count on the price of the stock declining, at which point you would repurchase the stock and return the shares to the lender. Your profit is equal to the proceeds from selling the stock immediately upon borrowing the shares less the cost of repurchasing the shares.
IRS Reporting Requirements
Proceeds from short sales are reported to the Internal Revenue Service as short or long-term capital gains, depending on whether the short sale was covered or uncovered. Covered short sales occur when the investor already owns the same or similar securities as the security sold short, which could be used to close out the transaction. Uncovered short sales are reported as short-term capital gains.
Covered short sales are reported as long-term capital gains if the covered security was held for at least one year before being transferred to the lender. The gain or loss is reported by your broker using IRS Forms 1099-B and 8949. In the case of a covered transaction, the tax basis of the covered security is netted out of the gain.
Treatment of Dividends
If dividends are paid by the company during the short sale period, the lender of the securities is entitled to the dividends. The short seller is required to make payments -- referred to as substitute payments -- in lieu of dividends to the lender. This amount is added to the stock basis. If a short sale position is held for no less than 46 days, the substitute dividend payment can be itemized and treated as investment interest payments, which serves as a tax deduction. In the case of extraordinary dividends, which are dividends that exceed the short sale proceeds by 10 percent -- or 5 percent for preferred stock -- the short sale must be held for a year, and the stock must be held for this duration also.