In general, a gain or loss is taken into account for tax purposes when realized. A gain or loss generally is realized, with respect to a capital asset, at the time the asset is sold, exchanged, or otherwise disposed of. That certainly makes sense. You don't have to pay taxes on "paper" gains -- you only have to pay taxes when you actually sell a stock and "realize" the gain on the sale. And, as you are all aware, you compute your gain or loss by comparing your net sales price on the sale with the cost (or basis) of the asset sold. Pretty simple stuff, eh?
Prior to the Taxpayer Relief Act of 1997, transactions designed to reduce or eliminate risk of loss on stock or financial assets generally did not cause income realization. For example, a taxpayer could lock in gains on securities by entering into a "short sale against the box" (i.e., when the taxpayer owns securities that are the same as, or substantially identical to, securities borrowed and sold short).
Example #1: Sam owns 1,000 shares of XYZ stock, with a cost basis of $20/share. The shares are now trading for $90 a stub. Sam would like to lock in his gains on this stock, but doesn't really want to sell the shares and face a large tax liability. So, instead of selling, Sam goes "short" on 1,000 shares of XYZ. Since Sam has not sold the original stock, there are no taxes to pay since the gain is not "realized."
Sam has taken virtually all of his cash out of the stock (via the short sale), but is now protected against any future losses on the shares. If the stock goes up, his "long" position increases, but his "short" position decreases. If the stock goes down, his "short" position increases, but his "long" position decreases. So Sam has, in effect, locked in his gain and received his cash without selling any of the shares or creating a taxable transaction. Of course, Sam will have his day of reckoning sometime in the future, but Sam may be able to manipulate his finances in such a way that the future gain will have less tax impact (such as being used to offset a substantial capital loss in the future). This is an example of a "short sale against the box."
The form of the transaction was respected for income tax purposes, and any gains on the substantially identical property were not recognized at the time of the short sale. Pursuant to rules that allowed specific identification of securities delivered on a sale, Sam could obtain open transaction treatment by identifying the borrowed securities as the securities delivered. When it was time to close out the borrowing, the taxpayer could choose to deliver either the securities held or newly purchased securities. The Code only provided rules to prevent Sam from using short sales against the box to accelerate losses or to convert short-term capital gains into long-term capital gains, or long-term capital losses into short-term capital losses.
But, that wasn't all. In addition, you could also lock in gains on certain property by entering into offsetting positions in the same or similar property. Under the straddle rules, when you realize a loss on one offsetting position in actively traded personal property, you generally can deduct this loss only to the extent that the loss exceeds the unrecognized gain in the other positions in the straddle. In addition, rules similar to the short sale rules prevented you from changing the tax characteristics of gains and losses recognized on the offsetting positions in a straddle.
This might be a little too much "tax speak" for many of you. If so, I apologize. I just want you to understand that there were methods out there that would allow (in the past) ways to lock in gains on a financial position without actually selling the position.
But all of this changed... not too long ago.
The New Law
According to the changes made by the Taxpayer Relief Act of 1997, you must now recognize gains (but not losses) upon a constructive sale of any appreciated financial position in stocks, a partnership interest, or certain debt instruments. A constructive sale occurs when you enter into one of the following transactions with respect to the same or substantially identical property:
All good questions... and all in due time. These and other issues are covered in Part II. Also check out IRS Publication 550 to read much more about this entire issue.
As always, should you have any questions or comments regarding this or any other tax matter, you can always direct them to me in the Tax Strategies discussion board.