7618 / What constitutes a "constructive sale" of an appreciated financial position?

In addition, if the appreciated financial position is a short sale, a futures contract (see Q 7588), a forward contract, or an offsetting notional principal contract, 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.²

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.³

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.⁴ 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.⁵

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.⁶ 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.⁷

Identified Pre-TRA ’97 Positions

Under 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.⁸

Definitions

A forward contract is a contract to deliver a substantially fixed amount of property, including cash, for a substantially fixed price.⁹ 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.¹⁰ 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.¹¹ 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.¹²

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 had occurred.¹³

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.¹⁴

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.¹⁵ 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.¹⁶ (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 701 for details of both definitions), and (b) the transaction is entered into with a view toward avoiding the purposes of the constructive sales rules.¹⁷

“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 7528, Q 7539). It would seem logical that the same definition would be used for purposes of constructive sales of appreciated financial positions.

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Planning Point: Do not confuse a “constructive sale of an appreciated financial position” with a “constructive ownership transaction” (see Q 7622 and Q 7623). 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.

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