When it comes to taxes, you can't avoid paying your share, but in terms of your trades and investments, you can certainly make a few tax moves to help minimize the bite—or at least help you avoid paying too much (or worse—running afoul of tax rules).
But don't wait too long to tie up those loose ends. Once the calendar flips to the new year, it may be too late, and the last thing you want is to get stuck dealing with past issues you thought were resolved.
For traders and investors, there are several unexpected items that could show up when you file taxes for the previous year like wash sales, constructive sales, and substitute payments. And if you've shorted a stock, if you're long a stock in a margin account, or if you trade broad-based index options, futures, or other so-called Section 1256 contracts, you may have special tax considerations.
Here are a few year-end tax tips to keep in mind for 2023.
If you sell a stock at a loss and then repurchase the same stock 30 calendar days before or after the loss-sale date, your trade is considered a wash sale. The wash sale rule is Uncle Sam's way of telling you that if you plan on maintaining a stock position, you can't nab tax deductions as your stock moves down in price. Although the wash sale concept is easy to understand, it's important to be aware of how this 61-day window may affect trades at the end of one year and the start of the next.
Let's suppose, come December, that you've decided to sell stock at a loss for tax-deduction purposes. If you close your position, say mid-December 2023, and repurchase the stock in January 2024 before the end of the 30-day window, you've technically made a wash sale. This means you can't deduct your capital loss for that stock from your 2023 taxes after all because you've carried the trade over to 2024. Note: Wash sale rules also apply to "short" positions that are closed at a loss (see more below).
Suppose you're long a stock whose price had risen, but you hear it may be headed for a downturn. Despite the negative news, you believe your stock is worth keeping, so you decide to hedge your investment by opening a short position against your long position. You're now long and short the same stock.
This is called "shorting against the box." It means you've locked in, or "boxed in," your current profit by initiating a new short position against the stock you're simultaneously holding. If you own, say, 100 shares of stock that had risen from $100 to $150, you have an unrealized profit of $50 per share. If you short 100 shares of the same stock while simultaneously holding it, you then create a situation in which any price movement from that point on, up or down, will no longer yield profit or loss. You've essentially hedged your entire position.
This has some tax implications. Because neither the long nor the short position has been closed—both are still active—your 1099-B won't show a gain. But technically, you do have a gain—the one you locked in. And that gain is considered a "constructive sale."
Although the IRS instructs brokers not to report constructive sales on client 1099s, according to the Taxpayer Relief Act of 1997, you're required to disclose and pay taxes on capital gains from that boxed position.
Constructive sales can also be triggered by certain options strategies, accounts held among different family members, and various other scenarios. Read IRS Publication 550 to get a more comprehensive understanding of the rules concerning "constructive ownership of stock." You may be required to report certain gains that have been excluded from your 1099-B.
Better yet, ask your tax professional for clarification on the rules concerning constructive sales and whether such an approach might be advisable for your investment practices. And remember, not all accounts offer the capability to initiate short-against-the-box positions.
Closing short positions
It's easy to assume that shorting a stock is like buying low and selling high in reverse. This may be true in principle, but when it comes to the IRS, long and short positions are treated differently.
The main difference is that all short positions, once covered, are considered short-term trades. How does that work? Although your purchase date is the date on which you bought the stock to cover your short position, your sale date is not the date on which you initiated your short position. Instead, it's the settlement date of your buy to cover, approximately one to two business days from the day you closed your position by purchasing the stock.
So, if you short sell a stock in October 2023 and buy to cover over a year later on November 10, 2024, your actual sale date occurs after your buy date. Your acquisition date is November 10, and the sale date is November 12, when the purchase settles.
If you plan to close a short position in late December in order to report your profits or losses for the 2023 tax year, December 27 is the last day to do this. Take that two-trading-day holding period for settlement into account. If you close your short position after December 27, it will settle in 2024, and your profit or loss will appear on your 2024 1099-B.
Suppose you own a portfolio of stocks generating dividend income. If you purchased any of these on margin, you might notice that some of the money you received is listed as payments rather than dividends on your year-end tax forms. And those payments will be taxed at ordinary income tax rates rather than the often more favorable dividend rates. They'll be reported via 1099-MISC rather than 1099-DIV/INT.
Why might you receive payments rather than dividends? If you buy a stock in a margin account, your broker can lend your shares to another investor who wants to short the stock. Although you're long, you're no longer on record as the "owner" of that stock if someone else shorts it. If your stock pays dividends, the investor who's short the stock must compensate you by "paying" the amount of dividends you're entitled to.
From a money standpoint, it's equivalent. But according to the tax man, it's not an actual dividend. It's a substitute payment.
In a cash account, the shares you purchase can't be loaned to short sellers, so you won't need to worry about substitute payments. In a cash account, your dividends will be dividends.
And if you happen to be the short seller? You can deduct your payments (dividend short charges) to the original owner as long as you held your position for at least 46 days. If you closed your position within 45 days or less, you'll have to add the amount of your dividend short charge to your buy-to-cover price.
For example, suppose you short stock XYZ at $100 per share. XYZ pays a dividend of $1, an amount you end up paying to the original stock owner. A month and a half later, XYZ falls to $90 per share and you buy to cover for a $10 profit. Because you held your short position for less than 46 days, you're unable to deduct your $1 payment on an itemized return. Instead, you can ask your broker to increase your cost basis so that your buy-to-cover price is now $91, for a profit of $9 instead of $10.
Bear in mind, your broker typically won't increase your cost basis unless you request it. So, if you plan on doing this, inform your broker right away. It beats having to amend your tax form.
Section 1256 contracts
Do you trade futures, options on futures, or options on broad-based indexes, such as the S&P 500® index (SPX) or Nasdaq-100® (NDX)? These products are treated with "mark-to-market" status. This means even if you didn't liquidate a position by the last trading day of the year, the IRS treats it as if you did and uses the closing price of that final trading day to figure your unrealized gain or loss. The closing price is "marked" and used as the cost basis going forward.
However, these products are also taxed on a "blended" long-term/short-term rate (the so-called 60/40 rule). This means 60% of gains or losses are treated as long-term positions and thus taxable at the capital gains rate—yes, even those trades you've only held for one day or less—and 40% are taxable as short-term positions, which are taxed at the ordinary income rate. With a capital gains rates ranging from zero to 20%, mark-to-market securities can potentially offer a considerable tax savings compared with the maximum ordinary rate of 37% (as of 2023).
With Section 1256 contracts, both realized and unrealized gains and losses will be reported at the end of the year. Unlike regular securities, whose realized gains and losses are reported on Form 8949, these contracts require investors to file Form 6781.
The bottom line on year-end tax planning
Year-end tax planning can be complicated, especially around the holidays. If you need a hand tying up loose ends, consider consulting a tax professional.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. Margin trading increases your level of market risk. For more information, please refer to your account agreement and the Margin Risk Disclosure Statement.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.0223-3SMP