Savvy investors who feel the value of a stock will go down can use a strategy know as a short sale.
Short sales have their own unique tax profiles and anyone considering a short sale should be aware of the tax consequences.
A visitor to The Canadian Tax Resource Blog asked about how dividends were handled from a tax perspective in a short sale:
What is the tax treatment of money paid on short sales of a stock that pays a dividend? For example – stock XYZ pays a dividend of $1.50/share. If you had shorted 100 shares, what happens to the $150 that gets taken from your account? Would this be considered to be ordinary income, or would this payment be added to the adjusted cost base of the security?
What is a Short Sale?
A short sale is where an you borrow a stock from an stock broker (like Questrade) and then turn around and sell it on the stock market. The term short position indicates that you have sold something that your didn’t own and must return to the broker at some future point or if the broker demands it.
Making Money With Short Sales
If you sell a borrowed stock and the price of that stock falls, then you can buy back the stock for less than you paid for it and return it to the broker.
However, the gain, which is the difference between what you sold it for and what you repurchased it at is NOT a capital gain but is taxed just like regular income.
The Risk Of Short Selling
If you take a short position in a stock and the price increases, you will be forced to buy back the stock for more than you paid for it. In this scenario the amount of the loss can be unlimited.
Obviously, short selling carries significantly more risk than purchasing a stock and holding it.
Income Tax and Short Selling
As mentioned above,gains and losses from short selling stocks will be treated as straight income as opposed to capital gains or losses.
When you borrow stocks from your brokerage firm, the broker will not receive any dividends during the period the stock has been lent to you. Therefore, you you must then pay the brokerage firm that dividend.
Many brokerage firms simply deduct the dividend amount directly from your account during the period you have borrowed the stock. For the individual, this amount cannot be deducted from computing income, but may be deducted to the extend you have other dividend income.