Time-Honored Tactic Delays Taxes

In the waning weeks of a bull market year, many investors who own profitable stock investments come face-to-face with a tax problem.

If they sell to cash in their gains before the close of trading on Dec. 31, they will be faced with a capital gains tax bill for 1996.

On the other hand, if they simply hold on until after Jan. 1, they run the risk of a market decline that might jeopardize their paper profits.

To the rescue, enter legions of brokers, financial planners and tax advisers with a suggestion: Consider “selling short against the box.”

This time-honored tactic, which lately has survived some calls by the Treasury and others to disallow it, has the effect of freezing an investment position.

The investment firm of A.G. Edwards & Sons provides this example of how it works:

You own 100 shares of a stock, bought five years ago for $20 a share, that now trades at $50.

The $5,000 you would realize from selling it is enough to meet the personal need for which you invested the money in the first place, and you are convinced the stock can’t go much higher based on the earnings trend at the company in question. But you don’t want the $3,000 profit to go into your tax accounts this year.

So you borrow another 100 shares from your broker and sell them, employing the maneuver known as short-selling that is commonly used by traders who hope to profit from market declines. After the short sale, your net exposure in the stock is zero - 100 shares long, 100 shares short.

Come January, you can instruct your broker to use the 100 shares you own to “cover” (that is, close out) your short position. At that time, the profitable sale of your original stock holding will be booked for tax purposes.

The first and most obvious risk in such a deal is that the stock might keep rising while you have your hedge in place. If that happens, you will get the benefit of none of that extra advance, since your short position accumulates losses as quickly as your original holding gains profits.

There are other important questions to consider as well, including transaction costs. On relatively small investments in particular, commissions to brokers and other costs of trading can add up quickly to a significant percentage of the amount you stand to gain or lose.

A decision whether to sell short against the box also may be heavily influenced by your personal circumstances.

If the investment in question is earmarked for a purpose like, say, paying school tuition, and it has reached the point where it will do its intended job, the argument may look strong for locking up your gain now before it has a chance to slip away.

The question then becomes whether postponing the day of tax reckoning on the investment will benefit you more in your tuition-paying mission than the costs of a tax-deferring strategy will hinder you.