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.
Obviously, some offsetting short positions (e.g., 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. See Q 7708 to Q 7710.
In 1997, Congress enacted the constructive-sale rules of section 1259. (42) If an investor executes a short sale and also owns appreciated shares of the same stock, then he is deemed to have sold the owned stock (rather than the borrowed stock).
Although many investors sell short against the box,(13) a variant of short selling that can defer or reduce tax liability, Estee Lauder Companies' 1995 IPO served as the impetus for the restructured assault on short sales.(14) Congress responded to the manner and degree to which the Lauders used short selling to effectuate their stock offering by passing tax legislation that treats certain financial transactions as "constructive sales" so long as those transactions function to lock in capital gain or loss with respect to the security involved.(15) The new law, codified as Internal Revenue Code section 1259, treats certain appreciated financial positions as constructive sales and taxes the capital gains on those positions.(16) This Note contends that section 1259 is flawed.
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. See Q 7708 to Q 7710.
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. The IRS had previously released a field service advice (FSA 200111011) that reached a different conclusion on a somewhat different set of facts.
For those forwards that do result in a constructive sale under IRC Section 1259, unless certain requirements are met for closing out the forward contract, the constructive sale generally will result in immediate recognition of gain by the taxpayer as if the appreciated financial position were sold and repurchased on the date of the deemed sale.
The application of the constructive sale rules of IRC Section 1259 to identified straddles is discussed in Q 7705.
It has been determined (under a ruling pre-dating the constructive sales rules of IRC Section 1259) that where a trust established by a seller closed a short sale after the death of the seller with stock it held for the seller's benefit, the basis of such stock generally would be its fair market value either on the date of the seller's death or on an alternate valuation date determined under IRC Section 2032.
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. The operation of these rules is explained at Q 1087 to Q 1089, and the effect of closing out or reopening certain transactions that are subject to constructive sale treatment is explained at Q 1088.