7621 / How is a constructive sale of an appreciated financial position treated for tax purposes?

If there is a constructive sale of an appreciated financial position, the taxpayer generally recognizes gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale (and any gain is taken into account for the taxable year that includes the date of the constructive sale).¹

For purposes of the tax treatment of the position after a constructive sale has been taxed under IRC Section 1259, the IRC states that “proper adjustment shall be made in the amount of any gain or loss subsequently realized with respect to such position for any gain taken into account” under the constructive sale treatment described above.² Since constructive sale treatment by definition applies only to appreciated financial positions, this provision should have the effect of increasing the taxpayer’s basis for purposes of any future disposition.³

The taxpayer must also begin a new holding period, as if the appreciated financial position were originally acquired on the date of the constructive sale.⁴ Except as provided in future regulations, a constructive sale generally is not treated as a sale for other IRC purposes.⁵

Part of the complexity of IRC Section 1259 treatment lies in the fact that some positions constitute an appreciated financial position, some transactions result in a constructive sale, and some (depending on the taxpayer’s other holdings) can do either. For example, a short sale can constitute either an appreciated financial position or a constructive sale, depending on the taxpayer’s other holdings. The same is true of certain futures or forward contracts and offsetting notional principal contracts.⁶

Under the plain wording of IRC Section 1259, the holding of an option constitutes an appreciated financial position, but not a constructive sale.⁷ However, as authorized by IRC Section 1259(c)(1)(E), future regulations may clarify the definition of “constructive sale” to include certain combinations of options.⁸ Furthermore, under the rules of IRC Section 1233 governing short sales, the acquisition of a put option is treated as a short sale; obviously, such an application in the context of IRC Section 1259 would have broad consequences.

According to the Blue Book, Congress’ intent was to treat any transaction that reduces both the risk of loss and the opportunity for gain as a constructive sale. Thus, for example, the holding of a stock position and the purchase of an at-the-money put option would not constitute a constructive sale since the option reduces only the taxpayer’s risk of loss, not the opportunity for gain.⁹ Future regulations should clarify the interaction of IRC Section 1259 and the treatment of options.