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Short Dividends / Section 263(h)
About 263(h): Payments in lieu of dividends in connection with short sales
Definition in simple terms: In general, if you make a payment in lieu of a dividend on a short position that you hold, you may not take a deduction for that payment unless you hold that short position for more than 45 days. If you do not take the deduction, you increase the cost basis of the stock used to close the short position by the amount of the disallowed deduction.
A more comprehensive definition of section 263(h): When a taxpayer holds a short position that receives a dividend, they generally make a payment in lieu of that dividend to the lender of the underlying stock. Section 263(h) prevents the taxpayer in question from deducting that payment as an investment expense if the short position was not closed within 45 days. In the event that this deduction is barred, the amount of the disallowed deduction is instead applied to the basis of the long position used to close the short sale. This means the same adjustment is eventually made, but there are notable differences.
- The loss is now taken at the capital gains rate instead of the ordinary income rate, which means it may be at a lower rate for the taxpayer, and is also subject to various loss limitations.
- The timing of the loss is shifted to the time of the covering of the short. This is usually inconsequential if the short and cover occur in the same year, but can cause the loss to be delayed if the cover short is in a year following the short sale.
- Assuming the cover short is at a loss after adjustment, it could potentially be disallowed due to the wash sale or straddle rules.
There are a few exceptions and cases for special treatment as well. These are:
- Longer period in case of extraordinary dividends. If the dividend in question is an extraordinary dividend, the minimum time you must hold the short is increased from 46 days to one year and one day. The full definition of an extraordinary dividend is covered in Section 1059(c), but in the general case an extraordinary dividend is one in which the dividend meets or exceeds 5% of the adjusted basis of a preferred stock or 10% of the adjusted basis of any other stock.
- Special rule where risk of loss diminished. The 45-day period (or 1 year period in the case of an extraordinary dividend) is suspended if the taxpayer holds, has an option to buy, or is under contractual obligation to buy any substantially identical stock.
Tax Analysis of Securities Transactions (TAST)
Activity: The taxpayer shorts a share of stock ABC on January 15th of 2014 at $125. On January 25th, the stock pays a $1 dividend, which the taxpayer makes a payment on to the holder of the underlying stock. On January 31st, the taxpayer covers the short position at $122, for a gain of $3.
Result: Because the taxpayer covered the stock within 45 days of shorting it, he/she is not allowed to deduct the $1 dividend payment as ordinary income at the end of the year. Instead, the $1 is added to the basis of the long position used to cover the short, resulting in an additional $1 of capital loss. As a result, the taxpayer reports only $2 of capital gains instead of the $3 generated by the cover.
Here’s what’s in the tax code
Section 263(h)(1) provides that, “(1) In general if (A) a taxpayer makes any payment with respect to any stock used by such taxpayer in a short sale and such payment is in lieu of a dividend payment on such stock, and (B) the closing of such short sale occurs on or before the 45th day after the date of such short sale, then no deduction shall be allowed for such payment. The basis of the stock used to close the short sale shall be increased by the amount not allowed as a deduction by reason of the preceding sentence.”
Click here to access Pub 550, the IRS publication that provides information and guidance on complying with sections of the Internal Revenue Code (IRC) that pertain to investment income and expenses.
To read specifically about payments in lieu of short dividends as described in Pub 550, click here.
Tax Analysis of Dividends
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