IRC 1259: Constructive Sales of Appreciated Positions

Internal Revenue Code (IRC) Section 1259 treats certain financial transactions as a “constructive sale.” This provision was part of the Taxpayer Relief Act of 1997 and addresses strategies investors used to defer taxable gains. Before this rule, an investor could hold an appreciated security and use a hedging transaction, like a short sale, to lock in profit without selling the original security. This eliminated the risk of a price decline while allowing the investor to postpone paying capital gains tax.

The constructive sale rule closes this loophole by identifying transactions that substantially eliminate a taxpayer’s risk of loss and opportunity for gain on an appreciated asset. When such a transaction occurs, the Internal Revenue Service (IRS) treats it as if the investor sold the original asset at its current market value. This “deemed sale” triggers immediate tax consequences, preventing the indefinite deferral of tax on locked-in investment gains.

Defining an Appreciated Financial Position

An “appreciated financial position” is the type of asset subject to the constructive sale rules. A position is “appreciated” if its fair market value is higher than its adjusted basis, which is the original purchase price plus acquisition costs. If selling the asset would result in a taxable gain, it is considered appreciated.

The rules apply to financial instruments like common stock, partnership interests, and certain debt instruments. Any position related to these assets, such as an option or contract to acquire them, can also be a financial position. Notably, these rules generally do not apply to most digital assets like cryptocurrencies, as they are not classified as stock, debt, or partnership interests.

The definition extends to complex instruments that derive their value from these core assets, including offsetting notional principal contracts and futures or forward contracts. An exception is provided for “straight debt,” which are non-convertible debt instruments that promise to pay a specified principal amount. Positions already subject to mark-to-market accounting rules are also excluded.

Transactions That Trigger a Constructive Sale

A constructive sale is triggered when a taxpayer with an appreciated financial position enters an offsetting transaction. The most common trigger is a short sale of the same or substantially identical property. In a “short against the box” transaction, an investor who owns stock borrows identical shares and sells them, locking in the value of their original shares since any future price decline is offset by a gain in the short position.

Another trigger is entering into an offsetting notional principal contract for the same or substantially identical property. A notional principal contract is a financial instrument where two parties exchange cash flows based on an underlying asset. If an investor with an appreciated stock enters a contract that pays them if the stock price falls and requires them to pay if it rises, they have neutralized their economic exposure, triggering a constructive sale.

Similarly, entering into a futures or forward contract to deliver the same or substantially identical property is a constructive sale event. A forward contract, for example, obligates the investor to sell their appreciated asset at a predetermined price on a future date, which fixes the sale price.

The concept of “substantially identical property” includes the exact same stock or security but can also encompass related financial instruments. For instance, a convertible security might be considered substantially identical to the underlying stock if the price movements of the two are closely correlated.

Tax Consequences of a Constructive Sale

When a constructive sale occurs, the taxpayer must recognize a gain as if the position was sold for its fair market value on the transaction date. This gain is calculated by subtracting the asset’s adjusted basis from its fair market value. The character of the gain, short-term or long-term, is determined by how long the taxpayer held the original position before the constructive sale.

To prevent double taxation, the basis of the original appreciated position is increased by the amount of the recognized gain. This “step-up” in basis ensures the already-taxed gain is not taxed again when the asset is eventually sold.

For example, assume an investor bought stock for $20,000. Years later, when the stock is worth $100,000, the investor enters into a short sale, triggering a constructive sale. The investor must recognize an $80,000 capital gain, and the basis in their original stock is adjusted to $100,000.

A new holding period for the appreciated financial position also begins on the date of the constructive sale. This determines if future appreciation is taxed at short-term or long-term rates. If the investor in the previous example later sells the stock for $110,000, the additional $10,000 gain will be short-term if sold within one year of the constructive sale date.

Exceptions to the Constructive Sale Rule

The Internal Revenue Code provides safe harbor exceptions to avoid a constructive sale. The primary exception is for short-term hedging transactions that are closed out promptly, provided the investor follows a strict set of rules.

To qualify for this exception, the taxpayer must meet three conditions. First, the offsetting transaction must be closed on or before the 30th day after the end of the tax year in which it was initiated. For a calendar-year taxpayer who enters into a hedge in June, this means the position must be closed by January 30th of the following year.

Second, after closing the offsetting transaction, the taxpayer must hold the original appreciated financial position for a 60-day period, starting on the date the hedge is closed. During this time, the investor is fully exposed to the asset’s market risks.

The final condition is that during this 60-day holding period, the taxpayer’s risk of loss cannot be reduced by entering another offsetting position. This includes having an option to sell, a contractual obligation to sell, or making another short sale. If all three conditions are met, the initial transaction is not treated as a constructive sale.