When you undertake a short sale, you will have to borrow shares from a third party and then sell them at current market price. If the stock goes down, you can buy the shares back at a lower price, return the borrowed shares and pocket the difference between the sales price and buyback price. The U.S. federal government and most states consider profits from short sale investments as taxable, leaving an investor responsible to pay capital gains tax.
Short sellers will not owe tax on any unrealized gains at the state or federal level until they actually take their profits. They will also not have to pay any self employment or Federal Insurance Contribution Act (FICA) taxes. This includes Social Security and Medicare taxes on the profits. The Internal Revenue Service considers such profits as unearned income, which allows them to keep a larger share of their gains.
A long investor who buys and sells a stock cannot lose more than 100 percent of the amount paid for the investment. A short investor has no limits on losses and can even experience a loss significantly greater than the total investment. This is because a stock could double or triple in price, leaving the investor owing money to a brokerage. It is for this reason that investors will usually close out short sale investments in less than one year, which incurs short-term capital gains taxes their profits. Investors who hold a stock short for a year or longer qualify for the lower long-term capital gains tax rates.
Most investors who profit off of a short sale will pay a short-term capital gains tax rate that matches their regular income tax bracket. Those who hold onto borrowed stock for greater than one year qualify for one of two tax rates, depending upon their income tax bracket. Investors who fall into the 25 percent income tax bracket or greater will pay 15 percent on their short selling profits, and those in the 15 percent income bracket or lower owe nothing.
Most states tax both short and long-term short sale profits at regular income tax rates. Some states, such as Alaska, New Hampshire, Tennessee and Washington do not levy capital gains at the state level, as of 2011. Four states, including Arkansas, Massachusetts, South Carolina and Wisconsin, provide residents with lower state tax rates on gains from stocks held a year or longer. Short sellers may have a larger liability if their local government, such as New York City, requires them to pay capital gains tax at the local level.
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