Constructive Sale Rule

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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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IRC section 1259 provides an exception to this realization-based timing rule.
IRC section 1259, added by the Taxpayer Relief Act of 1997, now provides that under some circumstances such short sales will be treated as a constructive sale of the stock held by the taxpayer.
a short sale) may also result in constructive sale treatment under the rules of IRC Section 1259 (see Q 7708 to Q 7710).
1q) It is unclear whether such treatment will be applied for purposes of the constructive sales rules of IRC Section 1259.
In 1997, Congress enacted the constructive-sale rules of section 1259.
We believe that such caution is warranted here and recommend that, until the proposed regulatory scheme under section 1259 is developed (and taxpayers have had an opportunity to comment on the proposed rules), the IRS should issue interim guidance confirming that taxpayers may apply a reasonable, goodfaith interpretation of the constructive-sale provisions.
Certain combinations of options, or options held contemporaneously with offsetting positions that have the effect of reducing both the taxpayer's risk of loss and opportunity for gain, may trigger constructive sales treatment under IRC Section 1259.
In Revenue Ruling 2003-7 [2003-5 IRB 1 (January 16, 2003)], the IRS held that a shareholder who entered into a variable prepaid forward transaction secured by a pledge of appreciated shares neither caused a sale of stock under general tax principles nor triggered a constructive sale under IRC section 1259.
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).
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).
For short sales that are not subject to the constructive sales rules of IRC Section 1259 (see Q 1022), the taxable event of the short sale occurred when the estate or trust "closed" the sale (see Rev.