We've discussed various issues regarding the new constructive sale rules. If you've missed those articles, you might want to take the time to read them... just to get up to speed.
Moving forward, there are still a few items to review. While we have focused on the "short-against-the-box" strategy in prior articles, there are other ways that a "long" position can be hedged. Many investors use other transactions to hedge their positions. So, the question then becomes: "Do the constructive sale rules impact the use of these other financial transactions to hedge a position?"
The answer is "no"... or "yes"... or even "maybe." I guess the best answer is: "It all depends."
I'm personally waiting for the regulations from the IRS on this very issue. Those regulations will address these issues and how they relate to constructive sales. They'll also likely provide specific examples for various financial transactions.
But, as of this date, those regulations are still not published. So, since the regulations are not yet available, the best source of information is the General Explanation of Tax Legislation (commonly referred to as the "Blue Book"), which was prepared by the Staff of the Joint Committee on Taxation in consultation with the staffs of the House Committee on Ways and Means and the Senate Committee on Finance. If you are really interested in this subject, you should read the entire text at:
(You'll want to look for the 1997 Joint Committee on Taxation Blue Book -- General Explanation of Tax Legislation Enacted in 1997, JCS-23-97, December 17, 1997). It's some long reading, but you should be able to find the appropriate section (Part II, Title X, under the heading "Revenue Increase Provisions.")
Remember that the constructive sale rules were implemented to impact transactions that had the effect of eliminating substantially all of your risk of loss and opportunity for income and gain with respect to the appreciated financial position. That's the standard and it's very clear. Applying this reasoning, Congress intended that transactions only reducing risk of loss or only reducing opportunity for gain would not be covered under the constructive sale rules.
Example: You hold an appreciated financial position in a stock. You then enter into a "put" with an exercise price equal to the current market price (an "at-the-money" option). Because such an option reduces only your risk of loss, and not your opportunity for gain, the above standard would not be met, and this would not be considered a constructive sale. Again, remember that the transactions the constructive sale rules affect are those that reduce both risk of loss and opportunity for gain. So, if you hedge only one end of the transaction, the constructive sale rules wouldn't apply.
Other financial positions might be affected. One is commonly called a "collar." In a collar, you commit to an option that requires you to sell a financial position at a fixed price (the "call strike price") and have the right to have your position purchased at a lower fixed price (the "put strike price").
Example: You enter into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the transaction is that you have transferred the rights to all gain above the $110 call strike price and all loss below the $95 put strike price. But, you have retained all risk of loss and opportunity for gain in the price range between $95 and $110. A collar can be a single contract or can be effected by using a combination of put and call options. So, while your gain and loss is eliminated above $110 and below $95, your gain or loss is alive and well between those two prices. Constructive sale?
Based on what we know, it's difficult to say if a collar will be treated as a constructive sale. I believe the IRS regulations will provide specific standards that take various factors into account with respect to the appreciated financial position, including its volatility. You can certainly expect that the regulations will review several aspects of the collar transaction. Important issues will include the spread between the put and call prices, the period of the transaction, and the extent to which the taxpayer retains the right to periodic payments on the appreciated financial position (such as the dividends on collared stock).
So, is your collar (which might be substantially different from mine) a constructive sale? That's up to you and the IRS (and likely your tax pro)... and your collective interpretation of the IRS code. This is one reason we are waiting for the regulations.
Another common transaction for which regulations would be helpful is a so-called "in-the-money" option. That is a put option where the strike price is significantly above the current market price, or a call option where the strike price is significantly below the current market price.
Example: You purchase a put option with a strike price of $120 for stock currently trading at $100. You have eliminated all risk of loss on the position for the option period. You may have also effectively transferred substantially all of the potential gain on the stock because you will only see gains if the share price goes above $120 per share. Constructive sale?
We'll have to wait for the regulations. I suspect they will provide a specific standard that takes into account many of the factors described above, including the yield and volatility of the stock and the period and other terms of the option.
For collars, options, and some other transactions, one approach the IRS might take in issuing regulations is to rely on option prices and option pricing models. The price of an option represents the payment the market requires to eliminate risk of loss (for a put option) and to purchase the right to receive yield and gain (for a call option). Thus, option pricing offers one model for quantifying both the total risk of loss and opportunity for gain with respect to an appreciated financial position, as well as the proportions of these total amounts that the taxpayer has retained.
In addition to setting specific standards for tax treatment of these and other transactions, it may be appropriate for Treasury regulations to establish "safe harbor" rules for common financial transactions that do not result in constructive sale treatment. An example might be a collar with a sufficient spread between the put and call prices, a sufficiently limited period, and other relevant terms such that, regardless of the particular characteristics of the stock, the collar probably would not transfer substantially all risk of loss and opportunity for gain. But, only time will tell what the Treasury will place in the regulations. Again, that is why these regulations (and the guidance they'll provide) are desperately needed.
The good news: It appears that whatever regulations are written, they will be prospective and not retroactive. So, if you (or your tax pro) determine that one of your transactions is not a constructive sale, but the regulations (when finally issued) say that it is, you may very well be off the hook. It may not require a restatement of your transaction, or an amended return (if the transaction took place in a prior year). I would anticipate that the only regulations that will be applied retroactively are those necessary to prevent abuse.
As you can see, the entire constructive sale issue is very complicated... potentially one of the most complicated tax issues since the passive loss rules. If you are non-Foolish and use a bunch of financial transactions to hedge your various stock positions, you had better become very well-versed in the constructive sale rules. It'll certainly complicate your life. And, while you are waiting for the regulations, you had better at least read IRS Publication 550 and the section in that publication on the constructive sale rules.
But, for Fools, simple buy-and-hold investors who don't try to guess or time the market and hedge transactions, these complicated tax issues have no meaning whatsoever. They simply won't apply to you... and you can effectively ignore them. That should give you much more time to spend with your family and friends, rather than with brokerage statements, tax codes, and regulations. And, isn't that what Foolishness is really all about?