The GameStop trading surge has brought short selling into the spotlight as investors marvel at the fast money that can be made through such trading. But many forget about the dangers of short selling, along with the taxes that come along with those quick profits.

“Short selling can be extremely dangerous, as the exposure to losses isn’t limited. The hedge funds who shorted GameStop learned that the hard way,” said Rob Seltzer, a CPA at Seltzer Business Management in Los Angeles.

In a short sale, an investor bets that the price of a stock will decline. The investor borrows shares of a particular stock from a broker, or another investor, to return the shares later hoping that the price will decline before they purchase the stock for repayment.

The taxation of short sales is treated the same as traditional stock sales: Stocks held for a year and one day are taxed at long-term rates, currently 15%. Stocks held for less than one year are taxed as ordinary income subject to the investor's current tax rate.

“The one area for short sellers that makes a large loss particularly painful are the limitations on capital losses,” Seltzer said. “You can only deduct $3,000 in excess of your capital gains. The remainder gets carried forward.”
“These types of transactions typically have a shorter turnaround and, for tax purposes, result in short-term capital gains or losses,” said Shazia Stagliano, a CPA and senior manager in the Philadelphia office of Friedman LLP.

Another wrinkle with short selling is the investor’s borrowing from the brokerage firm on margin “and that the broker charges interest to the investor for the amount borrowed,” said Steven Bernknopf, principal in the tax department in the Cranbury, N.J., office of Prager Metis CPAs.

“If you short 100 shares of XYZ company and the current price is $100 per share, the investor is borrowing $10,000 from the broker and will be charged interest for as long as they borrow the funds, whether the investor makes or losses money on the trade,” he said. “Generally, interest rates charged by brokers to investors is higher than traditional unsecured loan rates.”

“Most investors hear ‘year-end tax lost harvesting to offset profits,’ but equally important is tax gain harvesting,” Bernknopf added. “If an investor has a loss from short selling and has other securities with profits, they could sell the stock at a gain and use the loses to offset gains. Unlike stocks sold at a loss that cannot be bought back for 31 days because of the wash-sale rules, stocks sold at a gain can be repurchased immediately if the investor believes the stock is a good investment.”

Tax rates of short-term gains especially trip up newer investors. “If you hold the asset for one year or less, your capital gain is short-term,” Stagliano said. “Short-term gains are taxed at ordinary income rates and may be subject to the NIIT. For high income earners, this could result in a federal tax rate of up to 40.8%, which does not include state and local taxes. If you hold the stock for more than one year, you can take advantage of the reduced long-term capital gain tax rates.”
An option to short selling individual stocks for an investor is to purchase an inverse ETF index fund or inverse mutual fund, Bernknopf said. “These investments don’t require the investor to borrow money from the broker, avoiding interest costs,” he said. “The investor can still suffer losses, but they’d be limited to their investment.”

Regarding short selling, “you want to know that the return you are getting is large enough to offset the higher tax rates compared with traditional investing” with year-plus holdings and lower, long-term capital gains, Stagliano said. An estimated tax payment may also be required for a taxable gain.

“This type of investing is really gambling, as the stock price really has nothing to do with the success or viability of the company,” Seltzer said.