or investors looking to liquidate highly appreciated stock, here’s something to think about: With the possibility that the capital gains tax rate may be cut later this year, some investors who want to sell a particular stock now are thinking about using the short sale against the box technique.

On the surface, this idea seems intriguing, but be cautious, because more than a few risks are involved. Though the risks are high, the rewards for certain investors still might make this technique worth considering.

Why now?

The short against the box technique most commonly is used when you are selling a stock that has increased in value substantially and you want to defer paying a heavy capital gains tax. So you borrow shares of the same stock, and sell those shares, thus temporarily deferring the gains. You will not owe capital gains taxes on the sale until you close out the position (use your shares to return the borrowed shares).

Usually this strategy is a year-end tax-planning technique, used to defer taxes from one year to another. Most investors only use this technique if they expect their tax situation to be significantly different in another year.

Now, some investors are contemplating short against the box sales early in the year because there is a good chance the capital gains tax will be reduced before the end of the year. The President included a targeted capital gains cut for homeowners in his budget proposal, but the Republican majority in Congress is pushing for a broader-based capital gains cut as part of a budget agreement.

If Senate Republicans get their way, the capital gains tax rate will be cut from the current maximum rate of 28% to an effective new maximum rate of 19.8%. House Republicans introduced a bill, H.R. 14, that proposes a top capital gains rate of 14% for individuals and 28% for corporations. House Ways and Means Committee Chairman Bill Archer, R-Texas, says that bill will be their starting point in budget negotiations.

President Clinton’s proposed fiscal 1998 budget would eliminate the benefits of short against the box transactions by requiring that the gain be recognized immediately. This proposal’s effective date is the date of enactment of a budget bill; the proposal also applies to positions opened after Jan. 12, 1996, if the positions remain open 30 days after the date of enactment.

Last year, the President’s fiscal 1997 budget included the same proposed effective date, but Congress changed it to the date of committee action. (Congress and the President ultimately did not reach a budget agreement last year, but a deal looks more likely this year.) The effective dates may be pushed back this year as well, so the short against the box provision could go into effect as late as the date of enactment of a budget bill, in September or October.

Who Should Consider A Short Sale Against the Box?

Assuming you are contemplating selling a stock that has risen in value significantly, you may want to consider a short against the box sale if:

1. The stock has appreciated significantly since the date of purchase -- this should be a low-basis stock for you.
   
   
2. You own a large amount of the stock.
   
   
3. The stock (preferably) does not have a large short interest (that is, a large percentage of outstanding shares that have been sold short). A short against the box sale can be risky if the stock has a short interest or is thinly capitalized, as will be explained later. You also have to pay a higher margin interest rate to borrow stock with a large short interest.

How Do You Analyze The Benefits?

1. Check what your tax savings would be due to the rate differential if there’s a capital gains tax cut. Remember we only are talking about a possible 8% to 14% tax break if you are in the highest income tax bracket, depending on which (if any) capital gains tax cut proposal is enacted.
   
   
2. Certain taxpayers may realize some savings on estimated taxes. If you receive income unevenly throughout the year, you pay estimated taxes only for the period in which you receive the income. So if you delay recognizing a gain until October, then you don’t have to pay higher estimated taxes in June and September, but only in the following January. This might allow you to profit from the time value of money since you had access to the cash and interest earned for the whole period.
   
   
3. You may be able to invest 95% of the sale proceeds, based upon the 5% minimum margin requirements. This figure may vary according to your brokerage firm.

What Are the Transaction Costs?

1. You would owe the standard brokerage commission as on any normal stock sale. The cost can vary widely by brokerage firm, so check with your broker to find out if any extra transaction costs are involved in selling short against the box.
   
   
2. You also will owe margin interest on the stock you are borrowing. The interest rate can vary widely, depending on the brokerage firm and the amount borrowed.
   
   
3. If you are selling a stock with a large short interest, the interest rate charged by the brokerage firm may be higher than normal.

These costs can add up and eliminate the benefit of selling short against the box unless the stock is highly appreciated (which results in a large capital gain). The interest costs may not be prohibitive, though, because the interest you pay with a short against the box transaction generally is deductible as investment interest.

When the short against the box technique is used as a year-end tax-planning strategy, the investor may keep the position open just long enough to defer the gain from December to January. This minimizes the carrying costs because the open period is so brief.

The longer you keep a position open, though, the higher the transaction costs. You need to weigh the tax benefit of deferring the gain and possibly getting a lower tax rate against the transaction costs.

The pending legislation may make this strategy worth considering earlier than usual this year. Furthermore, taxpayers may even be able to reduce their taxes on the gain permanently rather than just deferring them to another tax year.

The Risks Involved

1. The political risk: There may be no capital gains cut this year or the cut may apply only to certain types of gain. If there’s no cut, you may have incurred transaction costs without any offsetting savings. Also, it’s just an educated guessing game about when or if the proposed tax changes will take effect.
   
   
2. The risk of a short squeeze. If the price of the stock rises, people who sold short will want to close out their positions quickly to avoid future losses, so they must start buying the stock to repay their borrowed shares. The increased demand keeps the stock price rising, which in turn induces more people to sell.

The rapid run up in stock price also may induce some shareholders who loaned their stock to their brokerage firm (for use in short sales) to sell their stock. If enough people remove their stock from the pool of borrowed shares, you may find yourself unable to borrow shares and be forced to deliver your shares to close out the position before you can take advantage of a possible tax cut. Short squeezes are more common for stocks with large short interest.

Sound economics and financial analysis should govern whether you want to sell any stock. Tax savings should not be the primary reason for selling a particular stock. Using the short against the box technique is something to consider only if you are planning on selling the stock now anyway. As always, check with your broker on the specific costs involved when determining whether this technique could be beneficial.

Use this chart to determine whether this tax-planning technique may work for you:

This is a sophisticated tax-planning technique that should be employed only after careful consultation with your tax and financial advisor.

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