7622 / What is a “constructive ownership transaction”?

IRC Section 1260 generally provides special treatment for “constructive ownership transactions” occurring after July 11, 1999.¹ In general, IRC Section 1260 targets the use of certain derivative contracts by taxpayers in arrangements that are primarily designed to convert what otherwise would be ordinary income and short-term capital gain into long-term capital gain. Congress was particularly concerned about derivative contracts with respect to partnerships and other pass-through entities. The use of such contracts would otherwise result in the taxpayer’s being taxed in a more favorable manner than if the taxpayer had actually acquired an ownership interest in the pass-through entity (i.e., being taxed at favorable capital gains rates, rather than at the applicable marginal rate for ordinary income).²

Generally, a taxpayer is treated as having entered into a constructive ownership transaction with respect to any financial asset if the taxpayer:

(1)   holds a long position under a notional principal contract (defined below) with respect to the financial asset;

(2)   enters into a forward contract (defined below) or futures contract (see Q 7588) to acquire the financial asset;

(3)   is the holder of a call option and the grantor (i.e., writer) of a put option (see Q 7561) on a financial asset, and the options have substantially equal strike prices and substantially contemporaneous maturity dates; or

(4)   to the extent provided in future regulations, enters into one or more other transactions (or acquires one or more positions) that have substantially the same effect as those described above.³

The types of transactions intended to be targeted by the regulations are those that replicate the economic benefits of direct ownership of a financial asset without a significant change in the risk-reward profile with respect to the underlying transaction.⁴ The Secretary may also issue regulations that permit taxpayers to mark constructive ownership transactions to the market instead of applying these rules, and to exclude certain forward contracts that do not convey substantially all of the economic return with respect to a financial asset.⁵

Mark to market exception. A constructive ownership transaction will not be subject to these rules if all of the positions are marked to the market (see Q 7592).⁶