Bridge over ocean
1 March 1978 Financial Analysts Journal Volume 34, Issue 2

Short Selling and the Capital Gains Tax

  1. Edward A. Dyl

A provision of the Internal Revenue Code allows an investor to take a capital gain while postponing the tax by selling the security short against the box and then closing out the short position in the next tax year. When an investor sells short against the box, however, he must balance the value of deferring taxation of the gain for a year against the opportunity cost of not receiving the proceeds until the position is closed out. (Since all transactions costs of the short sale and a conventional sale are the same, they do not enter into his decision.)

It turns out that the decision whether or not to sell short depends on the relative magnitude of the capital gain to be realized, the investor’s current and expected future tax rates respectively, the interest rate and the length of time the short position will remain open. In particular, the decision is highly sensitive to the length of time the short position must remain open. Thus one generally expects to see short selling only in the last month of the tax year.

Investors taking even modest capital gains have the incentive to defer taxation when they expect a lower tax rate in the subsequent year. On the other hand, for sufficiently high profit levels and tax rates, investors may profitably sell short against the box even in the face of an expected increase in their marginal tax rates.

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