Usually, investors want the market to go up because they've bought shares of companies and will make money when the company does well. However, some investors short-sell stocks, which means they borrow shares to sell and then hope to buy them back at a lower price. When you short-sell and the company pays a dividend, you owe money to the person or institution from whom you borrowed the shares.
When an investor short-sells stock in hopes of making a profit when buying them back, in some cases the company pays a dividend, which means the investor owes money from the share borrower.
Paying the Dividends
When you borrow the shares to sell in a short sale, you're responsible for paying the lender any dividends paid by the company during the time the short sale is open. For example, if you short-sell 100 shares of Company Q and it pays a $1.50 dividend, you owe the lender $150 immediately because the lender would have received that dividend had you not borrowed the shares.
Short-Term Short-Sale Taxes
When you short-sell a stock, you generally pay taxes on the amount you sold it for, minus the price you rebought the shares for to close the short sale. For example, if you short-sell shares for $1,500 and then repurchase them for $1,100, you have a $400 gain.
However, when you hold the short sale open for 45 days or less and the stock issues a dividend, you add the dividend amount to the amount that you repurchase the shares for. In the example, if you had also paid a $50 dividend while the short sale was open, you would subtract $1,150 rather than $1,100, to find your gain is only $350.
Long-Term Short Sale Taxes
Dividends you pay out-of-pocket on short sales that you hold open for 45 days or more, on the other hand, are treated differently. Instead of just adding them to your basis, you must deduct them separately as an investment expense on Schedule A. Of course, that means that you must itemize your deductions to claim it. If you don't itemize, the deduction is lost and can't be carried forward to a future year.
Dividend Timing to Consider
Companies don't simply pay dividends out of the blue. Instead, companies typically announce they are going to pay a dividend and give both an ex-dividend date and a dividend payment date. Only people still owning the stock on the ex-dividend date receive the dividend, so if you buy back the shares to close your short sale, you can avoid paying the dividend. However, paying a dividend isn't always a bad thing for a short sale. In theory, the stock price should drop by the amount of the dividend because the company is now worth less after paying out cash to the investors.