Constructive Sale Rule

Constructive Sale Rule

A section of the Internal Revenue Code clarifying the transactions that are subject to capital gains taxation. Basically, any transaction that essentially offsets a previously held position is subject to the tax, even if it is not a straight sale of a security. An example of a transaction that falls under the Constructive Sale Rule is a short sale against the box. It is formally called Section 1259.
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However, the Taxpayer Relief Act of 1997 created the constructive sale rule to force the recognition of gain on certain transactions that have the effect of neutralizing an investor's potential for further fluctuations in value.
The constructive sale rule applies to transactions involving "appreciated financial positions" that remain open beyond a statutorily determined time.
There are other exemptions from the constructive sale rule, such as short-term hedges relating to shorting the same stock, but for most situations the put option, the short sale against a similar but different stock or index, and the collar are the most often used hedging techniques that can avoid the constructive sale rules.
See the discussion of the constructive sale rules under "What Are the Tax Implications?
The real advantage of using mark-to-market accounting is that traders can claim losses as ordinary losses, and can be freed from concerns about the wash sale rule, constructive sale rule and straddles.
1259(c)(3), the constructive sale rule does not apply to certain short-term hedges.
The constructive sale rules are designed to prevent a taxpayer from entering into long-term hedging transactions that would defer gain indefinitely while substantially reducing or eliminating the risk of loss.
Example: Assume a taxpayer holds a long-term position in actively traded stock (which is a capital asset in the taxpayer's hands) and enters into a securities futures contract to sell substantially identical stock (at a time when the position in the stock has not appreciated in value so that the constructive sale rules of IRC Section 1259 do not apply).
In his 2001 article Frictions as a Constraint on Tax Planning, Dean Schizer notes how taxpayers can approximate a short sale against the box, but still avoid the constructive sale rules, with an equity collar.
For purposes of the constructive sale rules, any potential constructive sale transaction during the tax year will be disregarded if:
Example: Assume a taxpayer holds a long-term position in actively traded stock (that is a capital asset in the taxpayer's hands) and enters into a securities futures contract to sell substantially identical stock (at a time when the position in the stock has not appreciated in value so that the constructive sale rules of IRC Section 1259 do not apply).
The constructive sale rules do not apply to sales that close within 30 days after the end of the tax year, if the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed, and his risk of loss is not reduced at any time during the 60-day period (as described in Sec.
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