Constructive Sales Of Appreciated Financial Positions

In the past, many taxpayers have delayed recognition of income on securities or other properties by hedging their position to offset the risk of continually holding their position. Often, the gain is delayed so that the lower long-term capital gains rate would apply to the sale rather than the short-term ordinary income tax rate that would apply for short-term gains. To prevent this delay of income recognition, the tax law treats any hedging transaction of an appreciated financial position as a constructive sale.

Example: How Hedging a Position May Cause a Constructive Sale

You buy 100 shares of JXYZ stock on March 3 for $5 per share.
In December, the price per share has reached $12.
Although you would like to wait before selling it so that it qualifies for the long-term capital gains rate, you fear that the price will decline by then, so you buy a put on your stock on December 10.
However, because you have hedged your position, you are required to recognize a constructive sale of your stock at the fair market value of $12 per share on the date you purchased the put.
Therefore, you must recognize a short term gain of ($12 − $5) × 100 = $700 on your stock for that tax year.
Although you did not actually sell the stock, the law treats your purchase of a put as if you had also sold your stock and then immediately repurchased it, so your stock has a new holding period that begins on the date of the purchase of the put, December 10, and a new basis of $12 per share.

An appreciated financial position is the ownership of stock, options, debt instruments, partnership interests, and interests in certain publicly traded trusts, that would yield a gain if the position was sold.

However, an appreciated financial position does not include any instruments which would otherwise already be taxable, such as futures contracts subject to mark-to-market rules, or where there is little risk to the taxpayer in holding the position, such as holding debt instruments or interests in publicly traded trusts that qualify for the debt exception:

the taxpayer is unconditionally entitled to receive a specified principal amount;
the taxpayer receives fixed or variable interest payments that conform to §860G(1)(a)(3); and
the debt is not convertible into the stock of the issuer, or of any related person.

There are 4 basic types of transactions that are subject to the constructive sale rules:

short sales,
notional principal contracts (these contracts are designed for tax avoidance and do not seem to have true economic worth),
forward or futures contracts that are not marked to market, or
the purchase of a long position to cover a short position [IRC §1259 (c)].

Constructive sale rules do not apply to contracts, with terms of 1 year or less, that are not publicly traded, if they conform to the following safe harbor requirements:

the hedges are closed before the 31st day after the end of the taxpayer's tax year in which the hedge was acquired;
the taxpayer continues to hold the appreciated financial position at least 60 days after the hedge transaction is closed; and
during that time, the taxpayer does not hedge the long position.

Because exchange traded futures contracts — what the tax code refers to as Section 1256 contracts — are marked-to-market daily, gain or loss must be realized by the end of the year even if the taxpayer continues to hold the contract. Since futures contracts are taxed annually, the taxpayer cannot save on taxes by delaying its sale, so the constructive sale rules are unnecessary. The IRS gets its money, regardless.

Once a given position is treated as a constructive sale, then constructive sales rules will not apply to the same position while the position is held.

Example: Constructive Sale Rules Apply to the Same Position Only Once

On February 4, Year 1, you buy 100 shares of JXYZ stock for $4 per share.
On December 10, you sell short 100 shares of JXYZ stock at $10 per share.
- Hence, you must recognize a constructive sale of $10 − $4 = $6 per share when you shorted the stock. Your basis for your long position of 100 shares is $10 per share.
On February 15, Year 2, you close out your short sale by buying the replacement shares in the market while you continue to hold your original stock.
On April 17, you sell 100 shares of JXYZ stock short again.

Because you continued to hold the original position, your 2^nd short sale is not recognized as a constructive sale, so it does not have to be reported until it is closed out and any gain on the original stock does not have to be reported until the stock is actually sold.

However, if you hold another appreciated position and sell the original position before closing out the short sale, then constructive sale rules may apply to the other position.

Example: Constructive Sale Rules May Apply to Different Related Positions

On March 12, you buy 200 shares of JXYZ Corporation for $4 per share.
On December 10, you sell short 100 shares of JXYZ stock for $7 per share.
- You must recognize a gain of $7 − $4 = $3 per share on 100 shares on the constructive sale of your original position. Your tax basis for the shares is now $7 per share, while the remaining 100 shares still has a basis of $4 per share.
On January 30, you sell 100 shares of JXYZ stock for $10 per share.
- You must not only report a $10 − $7 = $3 gain on the 100 shares sold, but you must also recognize a constructive sale of the other 100 shares for a total gain of $10 − $4 = $6 per share, since you did not close out your short sale before selling some of your original position.
- The holding period for your remaining 100 shares of JXYZ stock begins on January 30, and its tax basis is $10 per share, since you are considered to have sold and then immediately repurchased the 100 shares because of the constructive sale treatment.

Tax Objective of Constructive Sale Rules

The purpose of the constructive sale rules is the same as the purpose for wash sale rules and the rules governing the taxation of short sales: to prevent taxpayers from trying to convert long-term losses into short-term losses or short-term gains into long-term gains by taking advantage of tax loopholes. The constructive sale rules do not change ultimate profits — they only change when the profits have to be reported and they also change the tax basis of the securities and their holding periods.

The constructive sale rules do not allow any losses, since they only apply to appreciated financial positions, which, by definition, applies only to gains. So if you buy stock for $16 a share, then later sell short the same stock for $15 a share, then the constructive sale rules do not apply, since it is not an appreciated financial position.