Fool.com: The Constructive Sale Rules - Part II
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The Constructive Sale Rules, Part II
The Rules

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By Roy Lewis

In Part I, we discussed the history surrounding short sales against the box and "straddles," and some of the reasons why the constructive sale rules were written into law. If you haven't read that article yet, take the time to review it. It'll give you some background that will help you understand this article.

Constructive Sale Rules

As we previously discussed, you are treated as having made a constructive sale of an appreciated financial position if you:
  • Enter into a short sale of the same or substantially identical property;

  • Enter into an offsetting notional principal contract relating to the same or substantially identical property;

  • Enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract that provides for cash settlement); or

  • Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).
If you have such a constructive sale, you must recognize any gain (but not loss) as though the position were disposed of at its fair market value on the date of the constructive sale. This gives you a new holding period for the position that begins on the date of the constructive sale. Then, when you close the transaction, you reduce your gain (or increase your loss) by the gain recognized on the constructive sale.

But what exactly is an "appreciated financial position"? It's really pretty simple. It is any interest you have in stock, a partnership, or a debt instrument (including a futures or forward contract, a short sale, or an option) that would result in a gain if you sold or otherwise disposed of it.

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into a transaction described above with a view toward avoiding the constructive sale treatment. For this purpose, a related person is:
  1. A member of your family. This includes only your brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).

  2. A partnership in which you directly or indirectly own more than 50% of the capital interest or the profits interest.

  3. A corporation in which you directly or indirectly own more than 50% in value of the outstanding stock.
There are other parties that are also considered "related," so this list is not inclusive at all. It's just a list of the most "common" related persons. For more detail on related party transactions, check out IRS Publication 550. But, let's move on to an example of how the constructive sale rules actually work.

Example #1: On May 1st, you bought 100 shares of ABC Corporation stock for $1,000. On September 3rd, you sold short 100 shares of ABC stock for $1,600 (the classic "short against the box"). You made no other transactions involving ABC stock for the rest of the year and the first 30 days of the following year (we'll discuss the importance of this statement a bit later). Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your ABC stock on the date of the short sale would have resulted in a gain. Therefore, you are required to recognize a $600 short-term capital gain from the constructive sale, for the tax year in which the sale took place. In addition, you are required to begin a new holding period in your ABC stock that starts on September 3rd, and your basis in these ABC shares would be increased to $1,600.

Example #2: On January 10th, you "short" 200 shares of XYZ Corporation stock for $5,000. On August 15th of the same year, you "go long" 200 shares of XYZ stock for $3,500. You made no other transactions in XYZ stock for the rest of the year, and the first 30 days of the following year (again, the relevance of this statement will be discussed later). Your "long" position will be treated as a constructive sale, and you will be required to recognize a short-term gain in the amount of $1,500 for the tax year in which the constructive sale took place. The new holding period for your short position will begin August 15th, and your new basis for your short position will be $3,500.

The importance of Example #2 is to show you that the rules work either way. An appreciated financial position could be a "long" position or a "short" position.

"Oh my goodness," you might be thinking to yourself. You could have gotten yourself into a constructive sale position without even knowing it, and now you might have to recognize a gain that you were never intending to recognize. Are you completely sunk? Not necessarily.

The Exceptions

You are not required to treat a transaction as a constructive sale if all of the following are true:
  1. You closed the transaction before the end of the 30th day after the end of your tax year; and

  2. You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction; and

  3. Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.

In other words, you are required to ignore the constructive sale rules if you close the offsetting position prior to January 30th of the following tax year, and you retain your original position for at least 60 days after closing the offsetting position. In addition, you are prohibited from entering into any other type of offsetting position for that same 60-day period.

If you re-read Examples 1 and 2 above, you'll see the statement "you made no other transactions in the stock for the rest of the year and the first 30 days of the following year," and you should now see the importance of this statement. If the proper moves are made, you can overcome the constructive sale rules.

Are you scratching your head and wondering how this all works in real life? I'm not surprised since it can get very confusing. I bet that you would like to see examples. In Part III, we look at some actual transactions from soup to nuts. Also visit IRS Publication 550 to read more information about the constructive sales rules.
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