7606. What constitutes a “constructive sale” of an appreciated financial position?Nuco Employeercline202014-10-01T14:43:00Z2014-10-01T14:43:00Z917489968Case Western Reserve University83231169314Site Map/Investments/Special Rules/Conversions, Constructive Sales, Constructive Ownership/Appreciated Financial PositionsTaxFactsDefaultArticle2006-01-04T00:00:00Z121191088-00-tf2.xml1088.00;#1946;#0x010100C568DB52D9D0A14D9B2FDCC96666E9F2007948130EC3DB064584E219954237AF3900242457EFB8B24247815D688C526CD44D009C4E67E972694125ABDA91AC61F5E51FTax Facts 2What constitutes a “constructive sale” of an appreciated financial position”?4400.00000000000TaxFactsDefaultArticleSBMEDIA\moss-admin2010-01-14T22:07:17Z7606. What constitutes a “constructive sale” of an appreciated financial position?A taxpayer is generally treated as having made a constructive sale of an appreciated financial position (see Q 7605) if the taxpayer or a related person (1) enters into a short sale (see Q 7523) of the same or substantially identical property, (2) enters into an offsetting notional principal contract (defined below) with respect to the same or substantially identical property, or (3) enters into a futures contract (see Q 7581) or forward contract (defined below) to deliver the same or substantially identical property.IRC Sec. 1259(c)(1)(A)-(C).In addition, if the appreciated financial position is a short sale, a futures contract (see Q 7581), a forward contract (see below), or an offsetting notional principal contract (see below), with respect to any property, a taxpayer who acquires the same or substantially identical property is generally treated as having made a constructive sale of the position.IRC Sec. 1259(c)(1)(D).It appears that if a taxpayer holds a long-term position in actively traded stock (which is a capital asset in the taxpayer’s hands) and enters into a securities futures contract to sell substantially identical stock at a time when the position in the stock has appreciated in value, the constructive sale rules will apply.See H.R. Conf. Rep. No. 106-1033 (CRTRA 2000), “Straddle Rules,” p. 1035.The Secretary of the Treasury is authorized to issue regulations providing that certain other positions or transactions having substantially the same effect as those described above will also constitute a constructive sale.IRC Sec. 1259(c)(1)(E). The types of transactions intended to be targeted by such regulations are those that result in the reduction of both risk of loss and opportunity for gain; transactions that reduce only one or the other would not be affected.See General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), p. 177 (the 1997 Blue Book).Nonpublicly traded property. A constructive sale does not include any contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security if the contract settles within one year after the date the contract is entered into.IRC Sec. 1259(c)(2). For this purpose, a marketable security means any security for which, as of the date of disposition, there was a market on an established securities market or otherwise.IRC Secs. 1259(c)(2), 453(f).Closed TransactionsIf a transaction that would otherwise be a constructive sale is closed within certain time limits, it will be disregarded. The IRC states that constructive sales treatment will not apply to any transaction that would otherwise be treated as a constructive sale during the taxable year if:(1)the transaction is closed before the end of the 30th day after the close of the taxable year (i.e., the “extended taxable year”);(2)the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date the transaction is closed; and(3)at no time during the 60-day period is the taxpayer’s risk of loss with respect to the position reduced by reason of holding an option to sell, an obligation to sell, or a short sale, being the grantor of a call option, or certain other transactions diminishing the risk of loss.See IRC Secs. 1259(c)(3), 246(c)(4).A closed transaction that is, in essence, reestablished (or replaced with a substantially similar transaction) before the 60-day period described above elapses, then closed again within the extended taxable year, may also be disregarded. The Internal Revenue Code states that if:(a)a transaction, which would otherwise be treated as a constructive sale of an appreciated financial position, is closed during the taxable year or during the 30 days thereafter (the extended taxable year), and(b)another substantially similar transaction is entered into during the 60-day period beginning on the date that the original transaction is closed, that (i) also would otherwise be treated as a constructive sale of the position, and (ii) is closed before the end of the extended taxable year in which the original transaction occurs, and the transaction meets requirements (2) and (3), above,then the substantially similar transaction will be disregarded for purposes of determining whether the original transaction met requirement (3) above (relating to the reduction of the taxpayer’s risk of loss during the 60-day period following the closed transaction).IRC Sec. 1259(c)(3)(B).Constructive Sales of Multiple Appreciated Financial PositionsThe IRC states that if there is a constructive sale of any appreciated financial position, such position is subsequently disposed of, and at the time of the disposition, the transaction resulting in the constructive sale of the position is still open with respect to the taxpayer or any related person (defined below), then solely for purposes of determining whether the taxpayer has entered into a constructive sale of any other appreciated financial position, the taxpayer will be treated as entering into the transaction immediately after the disposition. For purposes of this rule, an assignment or other termination will be treated as a disposition.IRC Sec. 1259(e)(1).The Blue Book explains the preceding paragraph (and provides an example) as follows: “A transaction that has resulted in a constructive sale of an appreciated financial position (e.g., a short sale) is not treated as resulting in a constructive sale of another appreciated financial position as long as the taxpayer holds the position that was treated as constructively sold. But when that position is assigned, terminated or disposed of by the taxpayer, the taxpayer immediately thereafter is treated as entering into the transaction that resulted in the constructive sale (e.g., the short sale) if it remains open at that time. Thus, the transaction can cause a constructive sale of another appreciated financial position at any time thereafter.”1997 Blue Book, pp. 174-175 (emphasis added).Example: Assume a taxpayer holds two appreciated stock positions and one offsetting short sale, and the taxpayer identifies the short sale as offsetting one of the stock positions. If the taxpayer then sells the stock position that was identified, the identified short position would cause a constructive sale of the taxpayer’s other stock position at that time.1997 Blue Book, p. 175.The IRC also provides that if a taxpayer holds multiple positions in property, the determination of whether a specific transaction is a constructive sale and, if so, which appreciated financial position is deemed sold will be made in the same manner as actual sales.IRC Sec. 1259(e)(3).Identified Pre-TRA ’97 PositionsUnder Section 1001(d)(2) of the Taxpayer Relief Act of 1997, if a taxpayer entered into a transaction that was a constructive sale of any appreciated financial position before June 9, 1997, and so identified the offsetting positions to the IRS by August 5, 1997, the rules of IRC Section 1259 shall not apply to determine whether a constructive sale occurred.Where a taxpayer with identified pre-TRA ’97 offsetting positions transferred the short position from the original broker to a second broker, the grandfather provision continued to apply.Rev. Rul. 2004-15, 2004-1 CB 515.DefinitionsA forward contract is a contract to deliver a substantially fixed amount of property, including cash, for a substantially fixed price.IRC Sec. 1259(d)(1). The definition of a forward contract includes a contract that provides for cash settlement with respect to a substantially fixed amount of property at a substantially fixed price.General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 185 (the 1998 Blue Book). According to the Blue Book, a forward contract results in a constructive sale only if it provides for delivery, or for cash settlement, of a substantially fixed amount of property and a substantially fixed price. If the amount of property provided for by the forward contract is subject to significant variation under the terms of the contract, it will not constitute a forward contract.See Rev. Rul. 2003-7, 2003-1 CB 363. Furthermore, an agreement that is not a “contract” for purposes of applicable contract law or that is subject to “very substantial contingencies” was not intended to be treated as a forward contract.1997 Blue Book, p. 176.But the Service distinguished a case in which in addition to entering into a forward contract pledging to deliver property that was the same as or substantially identical to an appreciated financial position that he held, a taxpayer loaned and delivered the shares to the other party at the time of the contract. In that case, the IRS found a constructive sale.TAM 200604033.The Service has ruled that a currency forward contract in which the amount ultimately received would be determined by both intervening currency fluctuations and market interest rates was in fact a debt instrument for tax purposes.Rev. Rul. 2008-1, 2008-1 CB 248.The Service had requested comments in 2008 on the tax treatment of prepaid forward contracts in which the purchase price is paid in advance of future delivery or cash settlement.Notice 2008-2, 2008-1 CB 252. The IRS was considering whether the parties to such contracts should be required to accrue any income or expense during the term of the transaction. That project was sidetracked, at least temporarily, however, by the debt crisis.The term offsetting notional principal contract means, with respect to any property, an agreement that includes (1) a requirement to pay (or provide credit for) all or substantially all of the investment yield (including appreciation) on such property for a specified period and (2) a right to be reimbursed for (or receive credit for) all or substantially all of any decline in the value of such property.IRC Sec. 1259(d)(2). (A “swap” is one type of offsetting notional principal contract).For purposes of the constructive sales rules, a person is related to another person with respect to a transaction if (a) the relationship is described in IRC Section 267(b) (which includes persons related by family as well as related entities) or IRC Section 707(b) (related partnerships) (see Q 529 for details of both definitions), and (b) the transaction is entered into with a view toward avoiding the purposes of the constructive sales rules.IRC Sec. 1259(c)(4).“Substantially identical stock or securities” is not defined in IRC Section 1259. Under earlier law, the meaning of the term as used for purposes of the short sale rules is the same as that used for the wash sale rules (see Q 7527, Q 7535). It would seem logical that the same definition would be used for purposes of constructive sales of appreciated financial positions.Note: Do not confuse a “constructive sale of an appreciated financial position” with a “constructive ownership transaction” (see Q 7608 and Q 7609). The former applies to certain hedging positions held by a taxpayer and results in deemed sale treatment and immediate recognition of gain. The latter applies to a taxpayer’s purchase of a derivative whose investment return is tied to the performance of a pass-through entity, instead of purchasing a direct interest in the pass-through entity itself, and results in the conversion of long-term capital gain into ordinary income. In other words, the former represents a deemed sale and the latter represents deemed (i.e., constructive) ownership.