Fool.com: The Constructive Sale Rules - Part III
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The Constructive Sale Rules, Part III
The Exceptions

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By Roy Lewis

In Part II, we reviewed how the constructive sale rules actually work. If you missed that article, go back and check it out. We also introduced the exceptions to the constructive sale rules. In this article, we'll look at the exceptions in much more detail.

The Exceptions

As we noted in Part II, 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.
  2. You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
  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 in Part II of this series, 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." You should now see the importance of this statement. If the proper moves are made, you can overcome the constructive sale rules. So let's see how the constructive sale rules work in real life.

Example #1: On May 1st last year, you bought 100 shares of ABC Corporation stock for $1,000. On September 3rd last year, you sold short 100 shares of ABC stock for $1,600. You held both of these positions until January 10th of this year. On that date, you close your offsetting short position for $1,800 and you keep your "long" position open until at least March 11th (at least 60 days). And, during that time, you don't enter into any other offsetting positions that would reduce your risk of loss on your original position. Since you have met all of the exceptions to the constructive sale rules, you have no constructive sale for last year. When you close your short position on January 10th, you'll recognize a short-term capital loss of $200 for this tax year. Your cost basis for your long position will remain $1,000, but your holding period will move to January 10th of this year.

Example #2: On May 1st last year, you bought 100 shares of ABC Corporation stock for $1,000. On September 3rd last year, you sell short 100 shares of ABC stock for $1,600. You held both of these positions until January 10th of this year. On that date, you close your offsetting short position for $1,800. But, because of the fluctuations in the stock, you sell your long position on March 1st (well before your required holding date of March 11th) for $1,500. You have now violated the exceptions to the constructive sale rules, and you must recognize the constructive sale of the original position last year (when the constructive sale actually took place), and not in the current year, when you actually sold the stock.

One very important thing that you should remember: Once you meet the constructive sale rules exceptions, you are then allowed (should you desire) to enter into another offsetting position. But, you'll have to be sure that you meet the exceptions for the new offsetting position.

Let's go back to Example #1. Since you met the exception for last year, anytime after March 11th of this year, you can again "short against the box" on your long position. But, to avoid constructive sale recognition for this year, all of the requirements must be met. And, you must make sure that you wait until after the 60-day "waiting period" has passed before entering into another offsetting position. Exception number three requires the waiting period.

Confusing? You bet. It can get very, very complicated. And, we have really only scratched the surface here, but this is certainly something that you need to understand should you decide that you want to "hedge" some of your stock positions.

In Part IV, we'll look at some of the other rules regarding constructive sales, and we'll also talk about how using options may or may not trigger the constructive sale rules. But if you can't wait for next week's installment, you can always read more about constructive sales in IRS Publication 550 at the IRS website.
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