Straddles And Other Transactions

March 13, 2024

7620 / Do the rules that govern constructive sales of appreciated financial positions apply to closed transactions?

<div class="Section1">If 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: <blockquote>(1) the transaction is closed before the end of the thirtieth 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.<a href="#_ftn1" name="_ftnref1">1</a></blockquote> 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: <blockquote>(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,</blockquote> 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).<a href="#_ftn2" name="_ftnref2">2</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 1259(c)(3), 246(c)(4). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1259(c)(3)(B). </div>

March 13, 2024

7622 / What is a "constructive ownership transaction"?

<div class="Section1">IRC Section 1260 generally provides special treatment for “constructive ownership transactions” occurring after July 11, 1999.<a href="#_ftn1" name="_ftnref1">1</a> 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).<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> Generally, a taxpayer is treated as having entered into a constructive ownership transaction with respect to any financial asset if the taxpayer: <blockquote>(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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7588">7588</a>) 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7561">7561</a>) 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.<a href="#_ftn3" name="_ftnref3">3</a></blockquote> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>).<a href="#_ftn6" name="_ftnref6">6</a> For the tax treatment of gain from a constructive ownership transaction, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7623">7623</a>. One example of a conversion transaction involving a derivative contract is set forth in the Senate Report for TREA ’99. The transaction involves an arrangement between a taxpayer and a securities dealer whereby the dealer agrees to pay the taxpayer any appreciation with respect to a notional investment in a hedge fund. In return, the taxpayer agrees to pay the securities dealer any depreciation in the value of the notional investment. The arrangement lasts for more than one year. The taxpayer is in substantially the same economic position as if he or she owned the interest in the hedge fund directly, yet the taxpayer may treat any appreciation resulting from the contractual arrangement as long-term capital gain. Moreover, any tax attributable to such gain is deferred until the arrangement is terminated.<a href="#_ftn7" name="_ftnref7">7</a> Definitions Financial asset means any equity interest in any pass-through entity and, to the extent provided in regulations, any debt instrument and any stock in a corporation that is not a pass-through entity.<a href="#_ftn8" name="_ftnref8">8</a> Pass-through entity is defined to include: (1) a regulated investment company (RIC, i.e., mutual fund) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7922">7922</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7936">7936</a>); (2) a real estate investment trust (REIT) (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7975">7975</a>); (3) an S corporation (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="805">805</a>); (4) a partnership (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7711">7711</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7714">7714</a>); (5) a trust (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7685">7685</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7686">7686</a>); (6) a common trust fund; (7) a passive foreign investment company; (8) a foreign personal holding company; (9) a foreign investment company; and (10) a REMIC (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7693">7693</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7694">7694</a>).<a href="#_ftn9" name="_ftnref9">9</a> A taxpayer will be treated as holding a long position under a notional principal contract with respect to any financial asset if the taxpayer has the right to be paid (or receive credit for) all or substantially all of the investment yield (including appreciation) on that financial asset for a specified period, and is obligated to reimburse (or provide credit for) all or substantially all of any decline in the value of that financial asset.<a href="#_ftn10" name="_ftnref10">10</a> The term forward contract means any contract to acquire in the future (or provide or receive credit for the future value of) any financial asset.<a href="#_ftn11" name="_ftnref11">11</a> <hr> Planning Point: Do not confuse a “constructive sale of an appreciated financial position” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>) with a “constructive ownership transaction.” 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 contract whose investment return is tied to the performance of a pass-through entity, instead of purchasing a direct interest in the pass-through entity, 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. <hr> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   TREA ’99, §§ 534(a), 534(c). <a href="#_ftnref2" name="_ftn2">2</a>.   S. Rep. No. 106-201 (TREA ’99). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1260(d)(1). <a href="#_ftnref4" name="_ftn4">4</a>.   S. Rep. No. 106-201 (TREA ’99). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1260(g). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1260(d)(2). <a href="#_ftnref7" name="_ftn7">7</a>.   S. Rep. No. 106-201 (TREA ’99). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1260(c)(1). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 1260(c)(2). <a href="#_ftnref10" name="_ftn10">10</a>.   IRC § 1260(d)(3). <a href="#_ftnref11" name="_ftn11">11</a>.   IRC § 1260(d)(4). </div></div>

March 13, 2024

7619 / When can constructive sales of multiple appreciated financial positions occur and how are they treated for tax purposes?

<div class="Section1">The 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 in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>), 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.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> 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.”<a href="#_ftn2" name="_ftnref2">2</a> <blockquote>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.<a href="#_ftn3" name="_ftnref3">3</a></blockquote> 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.<a href="#_ftn4" name="_ftnref4">4</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1259(e)(1). <a href="#_ftnref2" name="_ftn2">2</a>.   1997 Blue Book, pp. 174-175 (emphasis added). <a href="#_ftnref3" name="_ftn3">3</a>.   1997 Blue Book, p. 175. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1259(e)(3). </div></div>

March 13, 2024

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

<div class="Section1">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).<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> 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.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> Except as provided in future regulations, a constructive sale generally is not treated as a sale for other IRC purposes.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> Under the plain wording of IRC Section 1259, the holding of an option constitutes an appreciated financial position, but not a constructive sale.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> Future regulations should clarify the interaction of IRC Section 1259 and the treatment of options. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1259(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1259(a)(2)(A). <a href="#_ftnref3" name="_ftn3">3</a>. See also General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), p. 174 (the 1997 Blue Book). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 1259(a)(2)(B). <a href="#_ftnref5" name="_ftn5">5</a>. 1997 Blue Book, pp. 173-174. <a href="#_ftnref6" name="_ftn6">6</a>. IRC §§ 1259(b)(3), 1259(c)(1). <a href="#_ftnref7" name="_ftn7">7</a>. IRC §§ 1259(b)(3), 1259(c). <a href="#_ftnref8" name="_ftn8">8</a>. 1997 Blue Book, pp. 177-178. <a href="#_ftnref9" name="_ftn9">9</a>. 1997 Blue Book, p. 177. </div>

March 13, 2024

7623 / How is a "constructive ownership transaction" treated for tax purposes?

<div class="Section1">If a taxpayer has gain from a “constructive ownership transaction” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7622">7622</a>) with respect to any “financial asset” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7622">7622</a>) and that gain would ordinarily be treated as a long-term capital gain, such gain will instead be treated as ordinary income to the extent that the gain exceeds the net underlying long-term capital gain.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> For purposes of the constructive ownership transaction rules, net underlying long-term capital gain means the aggregate net capital gain that the taxpayer would have had if (1) the financial asset had been acquired for fair market value on the date the transaction was opened and sold for fair market value on the date the transaction was closed; and (2) only gains and losses that would have resulted from the deemed ownership under (1) were taken into account. If the taxpayer does not establish the amount of the net underlying long-term capital gain with respect to any financial asset by clear and convincing evidence, the amount of such gain will be treated as zero.<a href="#_ftn2" name="_ftnref2">2</a> If any gain is treated as ordinary income for any taxable year on account of these rules, the tax imposed for that year is increased by imposing interest at the underpayment rate for every prior tax year in which any portion of the constructive ownership transaction was open.<a href="#_ftn3" name="_ftnref3">3</a> The calculation of the interest is explained in IRC Section 1260(b)(2). No credits are allowed against the increase in tax.<a href="#_ftn4" name="_ftnref4">4</a> To the extent that gain is treated as long-term capital gain after the application of IRC Section 1260(a)(1) (i.e., instead of being recharacterized as ordinary income), it will be subject to the capital gain tax in the same manner as is the net underlying long-term capital gain.<a href="#_ftn5" name="_ftnref5">5</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses. Special rule where taxpayer takes delivery. Generally, if a constructive ownership transaction is closed by reason of taking delivery, the constructive ownership rules will be applied as if the taxpayer had sold all the contracts, options, or other positions that are part of the transaction for fair market value on the closing date. The amount of gain recognized under the preceding sentence will not exceed the amount of gain treated as ordinary income under IRC Section 1260(a). The IRC states that proper adjustments will be made in the amount of any gain or loss subsequently realized for gain recognized and treated as ordinary income under this special rule.<a href="#_ftn6" name="_ftnref6">6</a> The intended effect of IRC Section 1260 is to limit the amount of long-term capital gain a taxpayer can recognize from derivative transactions with respect to certain pass-through entities. The amount that may be treated as long-term capital gain is limited to the amount of such gain the taxpayer would have had if the taxpayer owned a direct interest in the pass-through entity during the term of the derivative contract. Any gain in excess of this amount is treated as ordinary income. In addition, an interest charge is imposed on the amount of gain that is treated as ordinary income. The provision does not alter the amount of gain that is not treated as ordinary income.<a href="#_ftn7" name="_ftnref7">7</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1260(a). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1260(e). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1260(b)(1). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1260(b)(4). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1260(a)(2). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1260(f). <a href="#_ftnref7" name="_ftn7">7</a>.   Joint Committee on Taxation, Summary of Conference Agreement on H.R. 1180 Relating to Expiring Tax Provisions and Other Revenue Provisions (JCX-85-99). </div></div>

March 13, 2024

7616 / How is a "conversion transaction" treated for income tax purposes?

<div class="Section1">In general, any gain that would otherwise be treated as gain from the sale or exchange of a capital asset and that is recognized on the disposition or other termination of any position held as part of a conversion transaction (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a>) will be treated as ordinary income to the extent that such gain does not exceed an “applicable imputed income amount,” as defined below.<a href="#_ftn1" name="_ftnref1">1</a> The purpose of IRC Section 1258 is to prevent the use of conversion transactions to transform ordinary income into capital gain.<div class="Section1"> “Applicable imputed income amount” (for purposes of a disposition or termination of a conversion transaction) means the amount of interest that would have accrued on the taxpayer’s net investment in the conversion transaction for the period ending on the date of such disposition (or on the date the transaction ceased to be a conversion transaction, if earlier) at a rate equal to 120 percent of the applicable rate reduced by any amounts previously treated as ordinary income under IRC Section 1258.<a href="#_ftn2" name="_ftnref2">2</a> Future regulations will provide for reduction of the applicable imputed income amount for amounts capitalized under IRC Section 263(g). A taxpayer’s net investment in a conversion transaction includes the fair market value of any position that becomes part of the transaction.<a href="#_ftn3" name="_ftnref3">3</a> The term “applicable rate” refers to the applicable federal rate as determined under IRC Section 1274(d) (compounded semiannually) as if the conversion transaction were a debt instrument, or, if the term of the conversion transaction is indefinite, the federal short-term rates in effect under IRC Section 6621(b) (relating to the determination of interest rates for overpayments and underpayments of tax) during the period of the conversion transaction (compounded daily).<a href="#_ftn4" name="_ftnref4">4</a> Regulations provide taxpayers with a method to net certain gains and losses from positions of the same conversion transaction before determining the amount of gain treated as ordinary income.<a href="#_ftn5" name="_ftnref5">5</a> If a taxpayer disposes of or terminates all the positions of an “identified netting transaction” within a 14 day period in a single taxable year, all gains and losses on those positions realized within that period (other than built-in losses, see below) are netted solely for purposes of determining the amount of gain treated as ordinary income. An “identified netting transaction” is a conversion transaction that the taxpayer identifies as an identified netting transaction on its books and records. Identification of each position of the conversion transaction must be made before the close of the business day on which the position becomes part of the conversion transaction.<a href="#_ftn6" name="_ftnref6">6</a> A position with a “built-in” loss that becomes part of a conversion transaction is taken into account at its fair market value, determined as of the date the position becomes part of the conversion transaction; but upon disposition or other termination of the position (in a transaction in which gain or loss is realized), the built-in loss will be recognized and its character will be determined without regard to IRC Section 1258.<a href="#_ftn7" name="_ftnref7">7</a> Thus, if a position with a built-in capital loss becomes part of a conversion transaction, upon a disposition of the position the built-in loss will retain its character as a capital loss for purposes of IRC Section 1258. “Built-in loss” means any loss that would have been realized if the position had been disposed of or otherwise terminated at its fair market value as of the time the position became a part of the conversion transaction.<a href="#_ftn8" name="_ftnref8">8</a> A “built-in loss” can also arise if a taxpayer realizes a gain or loss on any one position of a conversion transaction and, as of the date that gain or loss is realized, there is unrealized loss in any other position of the conversion transaction that is not disposed of, terminated, or treated as sold under any provision of the IRC or regulations within 14 days of and within the same taxable year as the realization event.<a href="#_ftn9" name="_ftnref9">9</a> Although built-in loss is not recharacterized for purposes of IRC Section 1258, it appears that property with a built-in gain will not be afforded the same treatment. IRC Section 1258(a) states that any capital gain that is recognized on the disposition of a position held as part of a conversion transaction will be recharacterized as ordinary income to the extent the gain does not exceed the applicable imputed income amount. Thus, it seems that gain generated prior to property’s inclusion in a conversion transaction is subject to recharacterization. The conversion transaction rules do not apply to the transactions of an options or commodities dealer entered into in the normal course of business; but limited partners and certain investors who have an interest in an enterprise other than as a limited partner will generally be subject to the conversion transaction rules.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1258(a). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1258(b). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1258(d)(4). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1258(d)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   Treas. Reg. § 1.1258-1(a). <a href="#_ftnref6" name="_ftn6">6</a>.   Treas. Reg. § 1.1258-1(b). <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 1258(d)(3). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1258(d)(3)(B). <a href="#_ftnref9" name="_ftn9">9</a>.   Treas. Reg. § 1.1258-1(c). <a href="#_ftnref10" name="_ftn10">10</a>.   IRC § 1258(d)(5). </div></div>

March 13, 2024

7614 / What is an "identified straddle"? How is it taxed?

<div class="Section1">An “identified straddle” is a straddle in which (1) all the original positions are acquired on the same day; (2) all positions are clearly identified in the investor’s records as being part of an identified straddle before the close of that day (or other time prescribed by future regulations), including which positions are offsetting with respect to other positions in the straddle; (3) no position is part of a larger straddle; and (4) all positions remain open at the close of the year, or were closed out on the same day during the year.<a href="#_ftn1" name="_ftnref1">1</a> Apparently, if a successor or substitute position replaces an original position of the straddle, the straddle ceases to be an identified straddle.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> In the case of an identified straddle, the loss deferral and wash sale rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a> do not apply. Instead, any loss realized with respect to a position in an identified straddle is treated as sustained no earlier than the day on which all positions making up the straddle are disposed of.<a href="#_ftn3" name="_ftnref3">3</a> The tax straddle short sale rules discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7599">7599</a> apply to identified straddles.<a href="#_ftn4" name="_ftnref4">4</a> While the IRC does not plainly set forth the application of the constructive sales rules of IRC Section 1259 to identified straddles, Congress’ intent is, apparently, that a straddle designated as an identified tax straddle under IRC Section 1092(a)(2) will be treated as a constructive sale of an appreciated financial position under IRC Section 1259. This generally results in immediate gain recognition, the start of a new holding period, and an adjustment to basis (unless certain requirements are met for closing out the position constituting the constructive sale)<a href="#_ftn5" name="_ftnref5">5</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>). The Blue Book states that where either position in such an identified transaction is an appreciated financial position and a constructive sale of that position results from acquiring the second position, Congress intended that the constructive sale would be treated as having occurred immediately before the identified transaction. It adds that the constructive sale will not prevent qualification of the transaction as an identified straddle transaction. It is also the intent of Congress that future regulations will clarify the extent to which straddle transactions will be subject to or excepted from the constructive sale provisions.<a href="#_ftn6" name="_ftnref6">6</a> Future regulations may clarify the manner in which these rules may be applied to identified straddles. A portion of any gain recognized upon disposition or other termination of a straddle that is part of a conversion transaction (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a>) may be treated as ordinary income. According to the IRC, these rules are applicable where substantially all of the taxpayer’s expected return from the investment is attributable to the time value of the taxpayer’s net investment in the transaction.<a href="#_ftn7" name="_ftnref7">7</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7615">7615</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7616">7616</a> for the definition and tax treatment of conversion transactions. <hr> Planning Point: Do not confuse “identified straddles,” discussed above, with what the Temporary Regulations refer to as an “IRC Section 1092(b)(2) identified mixed straddle.” The latter is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7608">7608</a>. <hr> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1092(a)(2)(B). <a href="#_ftnref2" name="_ftn2">2</a>.   General Explanation – ERTA, p. 284. <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 1092(a)(2)(A). <a href="#_ftnref4" name="_ftn4">4</a>.   Temp. Treas. Reg. § 1.1092(b)-2T. <a href="#_ftnref5" name="_ftn5">5</a>.   General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), p. 176-177 (the 1997 Blue Book). <a href="#_ftnref6" name="_ftn6">6</a>.   1997 Blue Book, p. 177. <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 1258(c). </div></div>

March 13, 2024

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

<div class="Section1">A taxpayer is generally treated as having made a constructive sale of an appreciated financial position (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7617">7617</a>) if the taxpayer or a related person (1) enters into a short sale (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7524">7524</a>) 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7588">7588</a>) or forward contract (defined below) to deliver the same or substantially identical property.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> In addition, if the appreciated financial position is a short sale, a futures contract (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7588">7588</a>), 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.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> Definitions A forward contract is a contract to deliver a substantially fixed amount of property, including cash, for a substantially fixed price.<a href="#_ftn9" name="_ftnref9">9</a> 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.<a href="#_ftn10" name="_ftnref10">10</a> 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.<a href="#_ftn11" name="_ftnref11">11</a> 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.<a href="#_ftn12" name="_ftnref12">12</a> 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.<a href="#_ftn13" name="_ftnref13">13</a> 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.<a href="#_ftn14" name="_ftnref14">14</a> 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.<a href="#_ftn15" name="_ftnref15">15</a> 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.<a href="#_ftn16" name="_ftnref16">16</a> (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 <a href="javascript:void(0)" class="accordion-cross-reference" id="701">701</a> for details of both definitions), and (b) the transaction is entered into with a view toward avoiding the purposes of the constructive sales rules.<a href="#_ftn17" name="_ftnref17">17</a> “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 <a href="javascript:void(0)" class="accordion-cross-reference" id="7528">7528</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7539">7539</a>). It would seem logical that the same definition would be used for purposes of constructive sales of appreciated financial positions. <hr> Planning Point: Do not confuse a “constructive sale of an appreciated financial position” with a “constructive ownership transaction” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7622">7622</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7623">7623</a>). 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. <hr> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1259(c)(1)(A)-(C). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1259(c)(1)(D). <a href="#_ftnref3" name="_ftn3">3</a>.   H.R. Conf. Rep. No. 106-1033 (CRTRA 2000), “Straddle Rules,” p. 1035. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1259(c)(1)(E). <a href="#_ftnref5" name="_ftn5">5</a>.   General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), p. 177 (the 1997 Blue Book). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1259(c)(2). <a href="#_ftnref7" name="_ftn7">7</a>.   IRC §§ 1259(c)(2), 453(f). <a href="#_ftnref8" name="_ftn8">8</a>.   Rev. Rul. 2004-15, 2004-1 CB 515. <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 1259(d)(1). <a href="#_ftnref10" name="_ftn10">10</a>.   General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 185 (the 1998 Blue Book). <a href="#_ftnref11" name="_ftn11">11</a>.   Rev. Rul. 2003-7, 2003-1 CB 363. <a href="#_ftnref12" name="_ftn12">12</a>.   1997 Blue Book, p. 176. <a href="#_ftnref13" name="_ftn13">13</a>.   TAM 200604033. <a href="#_ftnref14" name="_ftn14">14</a>.   Rev. Rul. 2008-1, 2008-1 CB 248. <a href="#_ftnref15" name="_ftn15">15</a>.   Notice 2008-2, 2008-1 CB 252. <a href="#_ftnref16" name="_ftn16">16</a>.   IRC § 1259(d)(2). <a href="#_ftnref17" name="_ftn17">17</a>.   IRC § 1259(c)(4). </div></div>

March 13, 2024

7613 / How are gains and losses from non-IRC Section 1256 positions that are part of a mixed straddle for which a straddle-by-straddle identification election has been made treated after all IRC Section 1256 positions are disposed of?

<div class="Section1">If one or more non-IRC Section 1256 positions are held after all the IRC Section 1256 contract positions in the straddle have been disposed of, any gain or loss realized on those non-IRC Section 1256 positions will be short-term capital gain or loss to the extent that such gain or loss is attributable to the period when such positions were part of the straddle.<a href="#_ftn1" name="_ftnref1">1</a> See Temporary Treasury Regulation Section 1.1092(b)-2T for the rules for determining the holding period with respect to such positions.</div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Temp. Treas. Reg. § 1.1092(b)-3T(b)(7). </div>

March 13, 2024

7617 / What is an "appreciated financial position"?

<div class="Section1">IRC Section 1259 generally provides special treatment for “constructive sales of appreciated financial positions.” Very generally, unless certain exceptions apply, such transactions result in a deemed sale with immediate recognition of gain (and a corresponding increase in basis in the property deemed sold), as well as the start of a new holding period (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>). The definition of “constructive sale” is explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>.<div class="Section1"> For purposes of the constructive sales rules of IRC Section 1259, an appreciated financial position is any position with respect to any stock, debt instrument, or partnership interest if there would be a gain were the position sold, assigned, or otherwise terminated at its fair market value.<a href="#_ftn1" name="_ftnref1">1</a> The term “position” is further defined as an interest, including a futures or forward contract (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7588">7588</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>), a short sale (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7524">7524</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7535">7535</a>), or an option (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7556">7556</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7581">7581</a>).<a href="#_ftn2" name="_ftnref2">2</a> Furthermore, it was the intent of Congress that offsetting notional principal contracts (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7621">7621</a>) also be included in the definition of “appreciated financial position,” and such a definition is supported by the language of IRC Section 1259(c)(1)(D).<a href="#_ftn3" name="_ftnref3">3</a> An interest in a trust that is actively traded will be treated as stock, for purposes of determining whether it is an appreciated financial position, unless substantially all (by value) of the property held by the trust is debt that qualifies for the debt interest exception described below.<a href="#_ftn4" name="_ftnref4">4</a> Debt instrument exception. The term “appreciated financial position” does not include any position with respect to debt (e.g., bonds) if: (1) the position unconditionally entitles the holder to receive a specified principal amount; (2) the interest payments (or other similar amounts) with respect to such position are payable at a fixed rate or, to the extent provided in regulations, at a variable rate; and (3) such position is not convertible (directly or indirectly) into stock of the issuer or any related person (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7618">7618</a>).<a href="#_ftn5" name="_ftnref5">5</a> Furthermore, the term “appreciated financial position” does not include any hedge of a position satisfying all three of the foregoing requirements.<a href="#_ftn6" name="_ftnref6">6</a> Consequently, to qualify for the exception for a position with respect to debt instruments, the position itself would have to either meet the requirements as to unconditional principal amount, nonconvertibility, and interest terms or, alternatively, be a hedge of a position meeting these requirements. A hedge for purposes of this provision includes any position that reduces the taxpayer’s risk of interest rate or price changes or currency fluctuations with respect to another position.<a href="#_ftn7" name="_ftnref7">7</a> Mark to market exception. The term “appreciated financial position” does not include any position that is marked to the market (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7592">7592</a>).<a href="#_ftn8" name="_ftnref8">8</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 1259(b)(1). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 1259(b)(3). <a href="#_ftnref3" name="_ftn3">3</a>.   General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), p. 175 (the 1997 Blue Book). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 1259(e)(2). <a href="#_ftnref5" name="_ftn5">5</a>.   IRC § 1259(b)(2)(A). <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 1259(b)(2)(B). <a href="#_ftnref7" name="_ftn7">7</a>.   General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 184 (the 1998 Blue Book). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 1259(b)(2)(C). </div></div>