Short Sale Against the Box: What It Is, How It Works, and Example

What Is a Short Sell Against the Box?

A short sell against the box is the act of short selling securities that you already own, but without closing out the existing long position. This results in a neutral position where all gains in a stock are equal to the losses and net to zero. The purpose is to avoid realizing capital gains from a sale to close, and so it has been restricted by regulators in practice.

For example, if you own 100 shares of ABC and you tell your broker to sell short 100 shares of ABC without selling your long position, you conducted a short sale against the box - with the long position in one account and the short position in another.

Key Takeaways

  • A "short sell against the box" is a strategy used by investors to minimize or avoid their tax liabilities on capital gains by shorting stocks they already own.
  • Instead of selling to close a long position, a long investor would instead sell short the equivalent of the long position in a separate account, creating a neutral position.
  • While it was popular in the past, the short sell against the box has increasingly become a restricted practice after an SEC and FINRA crackdown.
  • Alternative strategies exist, such as buying put options.

Understanding a Short Sell Against the Box

A short sell against the box, also known as "shorting against the box," is a tax-minimization or avoidance technique used by traders when they do not actually want to close out their long position on a stock. By selling short in a different account and maintaining the long position, no capital gains are realized and any new gains produced by one account will be equally offset by losses in the other.

The strategy is also utilized by investors who believe that a stock they own is due for a fall in price, but do not wish to sell because they believe the fall is temporary and the stock will rebound quickly.

Restrictions and Tax Avoidance

Prior to 1997, the main rationale for shorting against the box was to delay a taxable event. According to tax laws that preceded that year, owning both long and short positions in a stock meant that any paper gains from the long position would be removed temporarily due to the offsetting short position. The net effect of both positions was zero, meaning that no taxes had to be paid.

The Taxpayer Relief Act of 1997 (TRA 97) no longer allowed short selling against the box as a valid tax deferral practice. Under TRA97, capital gains or losses incurred from short selling against the box are not deferred. The tax implication is that any related capital gains taxes will be owed in the current year.

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) further regulated when sellers are allowed to sell short. For instance, in February 2010, the SEC adopted the alternative uptick rule, which restricts short selling when a stock drops more than 10% in one day. In that situation, those engaging in a short sale (even if the shares are already owned) usually must open a margin account.

A viable alternative strategy is instead buying a put option, which gives investors the right, but not the obligation, to sell the shares. Buying a put option has a per-share cost associated with it, which is comparable to a short sale transaction. However, like all strategies that use options, put options are subject to the effects of time decay. This represents a cost that must be managed in order for options strategies to work effectively.

Example of Shorting Against the Box

As an example, say you have a big paper gain on shares of ABC in your main brokerage account, which is not a margin account. You think that ABC has reached its peak and you want to sell. However, there will be a tax on the capital gain. Perhaps the next year you expect to make a lot less money, putting you in a lower bracket. It is more beneficial to take the gain once you enter a lower tax bracket.

To lock in your gains this year, you short the ABC's shares in your margin account. As is customary, you borrow shares from a broker. When your bet (hopefully) comes true, you return the shares that you already owned before the short to the broker, thereby circumventing the taxable event.

Is Selling Against the Box Legal?

No, selling short against the box to avoid taxes is illegal under the Taxpayer Relief Act of 1997.

How Does Short Selling Work?

Selling short involves borrowing shares from your broker in order to sell them in the market, with the hope of buying them back at a lower price, for a profit. While the shares are borrowed and shorted, you must pay interest on the value of the borrowed shares. Because of this, short selling is only allowed in margin accounts.

What Is a Box Spread Using Options?

A box spread is an options strategy used to create a synthetic loan, to borrow or lend money at an implied interest rate that may differ from one's traditional lending sources. A box spread involves buying a bull call spread along with a matching bear put spread, where the payoff will always be the difference between the two strike prices. So if you can buy a 100-pt box for $99, it will gain $1 in value by expiration.

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