The IRS has said basket options are not options at all.

The Treasury Department and IRS issued guidance on Wednesday to effectively halt the use of so-called “basket options,” a tax loophole that high-net-worth investors use when investing in alternatives.

Treasury and IRS noted in their joint guidance their concern that taxpayers are using basket option contracts to “inappropriately defer income recognition and convert ordinary income and short-term capital gain into long-term capital gain.”

In some cases, “taxpayers are mischaracterizing a transaction as an option to avoid” paying taxes.

Because of this loophole, Treasury and IRS said they are now identifying a basket option contract and substantially similar transactions as “listed transactions,” which means that those using the strategies must declare them on their tax returns. Those who don’t would face penalties.

Senate Finance Committee Ranking Member Ron Wyden, D-Ore., applauded Treasury and the IRS’s move, stating they’re heeding his call to them in June to take action and “bring the hammer down on these basket options once and for all.”

“The law is very clear in this area – basket options are a tax shelter,” Wyden said in a statement. The guidance from the administration “is a win for taxpayers and brings us one step closer to a more fair and equitable tax code.”

He noted in a June 16 letter to Treasury Secretary Jack Lew an internal memo issued by the IRS in 2010 stating that basket options “were not options at all and instead simply an account of securities owned by the alternative investment vehicle.” Therefore, Wyden stated, “profits from trades of assets held for less than a year would be subject to the higher short-term capital gains.” Unfortunately, the IRS memo, Wyden continued, “has no legal authority and many hedge funds — and banks that sell these these ‘basket options’ — are disregarding the IRS guidance and continue to market this product.”

— Check out IRS Has New Favorite People to Audit on ThinkAdvisor.