An individual acquired 500 shares of stock on December 20, year 1, for a personal portfolio. On March 15, year 2, the individual executed a short sale of 500 shares of the stock. On December 21, year 2, the individual delivered the 500 shares to cover the short sale. Which of the following statements best characterizes the gain or loss on the short sale?

1 The transaction will be treated as ordinary income because of the March short sale.

2 The transaction will be treated as a long-term capital asset sale.

3 The transaction will be treated as a 40% short-term/60% long-term capital asset sale.

4 The transaction will be treated as a short-term capital asset sale.

4) The transaction will be treated as a short-term capital asset sale.

Explanation:

This person engaged in a short sale, which is classified as a short term capital asset sale since the holding period was shorter than 1 year (March 15 - December 21).

A short sale takes place when an investor sells property that he either doesn't own, or owns but doesn't want to sell. This sale is done in two steps:

the investor borrows the stock and delivers it to the buyer the investor later purchases the same stock (hopefully at a lower cost) and returns them to the lender

The investor cannot realize any gain or loss until he/she actually returns the stocks to the lender. If the investor managed to buy the stocks at a lower price, he/she will have realized a capital gain.