Offsetting dividends in a Roth and in a non-retirement account

dcwriter2 · Oct 2, 2021

Indulge me here. Let’s say I am long 1000 PM in my Roth IRA and then short 1000 in a different account, fully taxable, with a different broker. Hold both. My Roth dividends are not going to be taxed. But I can still deduct the dividends I pay in my short account, giving me a net gain, a slight one, but a riskless one. Correct? What would the IRS say?

Girija · Oct 2, 2021

You like to max out deductions, don't you. For the kind of deductions you are talking about you should get tax prepared by the league of KPMG/ Ernst and young etc. Then they will take the liability of audit or 9 out of 10 times irs wouldn't want to mess with you.
There is a 45 day test for deduction of dividend on short sale but that gets reset if you hold offsetting positions which includes even a call. So the answer is a resounding no.

Girija · Oct 2, 2021

Also not sure you know this or not but there is also a alternative minimum tax that a system in irs works out to flag potential violations. You can also be reqd to file amt under certain conditions.

Trader200K · Oct 2, 2021

It would also be a negative if in the long term the short, taxable asset grew more with the Roth instrument shrinking. Effectively, exchanging tax free assets for taxable. The vice versa though, managed cleverly, would be essentially be shuffling tax deferred money to tax free … without paying the conversion tax.

Hmmm … so what would be the downside of picking an unrelated instrument to short in the taxable accnt that is ~85% or better correlated w the Roth long … say w/o divs?

Keep all the tax free divs with only a modest increase in principle risk while getting the IRS issue negated. Not risk-less of course, but def better positioned before a harsh or even a black swan event. Picking the plays would be the challenge.

R1234 · Oct 2, 2021

Trader200K said:
The vice versa though, managed cleverly, would be essentially be shuffling tax deferred money to tax free … without paying the conversion tax.
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There has to be a rule that forbids this. Indirectly transferring money into a Roth IRA through hedging against a taxable account.

ph1l · Oct 2, 2021

dcwriter2 said:
What would the IRS say?
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The IRS might say "that's an illegal short against the box." So, it might be a risky thing to try.
https://invest-faq.com/short-against-the-box/

SHORT AGAINST THE BOX

Short sale against the box, or simply short against the box, is the act of selling short securities that you already own. For example, if you own 200 shares of FON and tell your broker to sell short 200 shares of FON, you have shorted against the box. Note that when you short against the box, you have locked in your gain or loss, since for every dollar the long position gains, the short position will lose and vice versa.

This article discusses a strategy that once helped investors delay a taxable event with relative ease. Revisions made to the tax code by the act of 1997 effectively eliminated the “Short Against The Box” strategy as of July 27, 1997 (although not totally – see the bottom of this article for a caveat).

Short Against the Box Alternative
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An alternative way to short against the box is to buy a put on your stock. This may or may not be less expensive than doing the short sale. The IRS considers buying a put against stock the same as shorting against the box.

The name comes from the idea of selling short the same stock that you are holding in your (safety deposit or strong) box. The term is somewhat meaningless today, with so many people holding stock in street name with their brokers, but the term persists.

The obvious way to close out any short-against-the-box position is to buy to cover the short position and to sell off the long. This will cost you two commissions. The better way is to simply tell your broker to deliver the shares you own to cover the short. This transaction is free of commission at some brokers.

Shorting Against the Box Example
The sole rationale for shorting against the box is to delay a taxable event. Let’s say that you have a big gain on some shares of XYZ. You think that XYZ has reached its peak and you want to sell. However, the tax on the gain may leave you under-withheld for the year and hence subject to penalties. Perhaps next year you will make a lot less money and will thus be in a lower bracket and therefore would rather take the gain next year. Or maybe you have some other reason.

Or perhaps you think, “This is great! I have a stock that I’ve held for 9 months but I think it has peaked out. Now I can lock in my gain, hold it for 3 more months, and then get a long-term gain instead of a short-term gain, saving me a bundle in taxes!”

Bzzt. The answer is absolutely NOT! Unfortunately, the IRS has already thought of this idea and has set the rules up to prevent it. From IRS Publication 550:

If you held property substantially identical to the property sold short for one year or less on the date of short sale or if you acquire property substantially identical to the property sold short after the short sale and on or before the date of closing the short sale, then:

Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain; and

Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.

So if you have held a stock for 11 months and 25 days and sell short against the box, not only will you not get to 12 months, but your holding period in that stock is zeroed out and will not start again until the short is closed. Note that your holding period is not affected if you are already holding the stock long-term.

The 1997 revisions to the tax code define (or extend) the idea of “constructive sales.” A constructive sale is a set of transactions which removes one’s risk of loss in a security even if the security wasn’t actually disposed of. Shorting against the box as well as certain options and futures transactions are defined as being constructive sales. And any constructive sale is interpreted as being the same as a real sale, which is why this strategy is no longer effective (don’t you hate it when the rules change in the middle of the game?).

What is The Short Against the Box Tax Loophole?
For those who have read this far, there does appear to be a small loophole in the 1997 revisions that permit shorting against the box to delay a taxable event. If you have a short against the box position and then buy in the short within 30 days of the start of the tax year and leave the long position at risk for at least 60 days before offsetting it again, the constructive sales rules do not apply. So it appears that you can continue shorting against the box to defer gains, but you have to temporarily cover the short and be exposed for at least 60 days at the beginning of each and every year.
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Trader200K · Oct 5, 2021

I clearly don’t know the tax code and in the current enviro I wouldn’t even try it … because … well you know all that.

Sig · Oct 11, 2021

So first off, it's important to understand what happens to a stock the when it goes ex. It drops by the amount of the dividend, all other things being equal. So in general, your short account will see a gain by the amount of the dividend that exactly equals the loss from the dividend, again assuming the stock doesn't experience a stock specific gain or loss at the same time. Dividends are entirely neutral events. So the idea doesn't work from a sheer mechanics perspective.

Additionally, the IRS does have guidance that disallows the ability to claim a loss in the taxable accounts when performing identical wash sales which are designed to move money from a taxable to a Roth account, I'd need to do some digging to find the exact citation.

dcwriter2 · Oct 12, 2021

Tks for that last note, although identical is still stumping me in this world of easy high correlation data and trades.

Sig · Oct 12, 2021

dcwriter2 said:
Tks for that last note, although identical is still stumping me in this world of easy high correlation data and trades.
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There is a ton of definitions, private letter rulings, and case law on the definition of identical when you look up the term "substantially identical" in conjunction with the term "wash sale". It's definition is pretty clear, its just not necessarily all in one place.