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Home > Resources > About Constructive Sales


What is a Constructive Sale?
Understanding the IRS Constructive Sale Rule,
Section 1259

All About Constructive Sales
Constructive Sale Definition

A simple definition of a constructive sale: A constructive sale is created when you hold an appreciated position, and enter into an opposite position in the same (or substantially identical) property (read about "substantially identical" on our wash sale page). The taxpayer recognizes gains as if the position were closed on that date, and then immediately re-opened.

The constructive sale rule also affects the holding periods involved with the transactions.

In general, most times if there is a constructive sale, there will also be a straddle. But there is often a straddle when there is no constructive sale. (Please see our Straddles section.)

When you close the position that was constructively sold, you may trigger another constructive sale. If the crossing position is still open at this time, it can cause another constructive sale if there is another appreciated position at this time.(See Example 4, Long Partial Constructive Sale with Closeout)

Most debt positions, and any position marked-to-market under section 1256, are not eligible to be constructively sold.

Many combinations of transactions can make up a constructive sale, including those using short positions or substantially identical securities. As a result, it is important to take into account the different interactions between constructive sales and other taxable events, such as wash sales (I.R.C. § 1091), straddles (I.R.C. § 1092) and qualified dividends (I.R.C. § 1(h)(11)).

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Examples of Constructive Sales
Example 1 — Long Constructive Sale

Activity:
  • The taxpayer buys a single share of stock ABC on January 3rd of 2011 for $100.
  • On December 30th, the taxpayer shorts one share of stock ABC at $125.
Long Constructive Sale
Event Date Investment Quantity Event Type Total Amount
01/03/2011 ABC 1.00 Buy 100
12/30/2011 ABC -1.00 Short Sell -125

Result:
  • The taxpayer recognizes a short-term capital gain of $25 achieved on December 30th due to a constructive sale created on that date.
  • The cost basis adjustment is $25, meaning the cost basis of the long share purchased on January 3rd is increased from $100 to $125 and the apparent tax date of this position is reset to December 30th.
  • But this configuration also forms a straddle, so the day-counter for the holding period is suspended while the straddle is in place.
  • See our webinar: Tax Implications of Straddles for further discussion on this topic.
Example 2 — Short Constructive Sale

Activity:
  • The taxpayer shorts a single share of stock ABC on January 3rd of 2011 for $100.
  • On February 15th, the taxpayer buys (long) one share of stock ABC at $80.
  • Both positions remain open as of January 30, 2012.
Short Constructive Sale
Event Date Investment Quantity Event Type Total Amount
01/03/2011 ABC -1.00 Short Sell -100
02/15/2011 ABC 1.00 Buy 80

Result:
  • The taxpayer recognizes a short-term capital gain of $20 achieved on February 15th due to a constructive sale created on that date.
  • The tax basis of the January 3rd short is adjusted to $80.
  • This configuration also forms a straddle.
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Example 3 — Long Partial Constructive Sale

Activity:
  • The taxpayer buys two shares of stock ABC on January 3rd of 2011 for $100 each.
  • On February 15th, the taxpayer shorts one share of stock ABC at $125.
  • Both positions remain open at year end, December 31st 2011.
Long Partial Constructive Sale
Event Date Investment Quantity Event Type Total Amount
01/03/2011 ABC 2.00 Buy 200
02/15/2011 ABC -1.00 Short Sell -125

Result:
  • The taxpayer recognizes a short-term capital gain of $25 achieved on February 15th due to the creation of a constructive sale on that date.
  • This represents half of the unrecognized gain on the ABC position on the day the short was executed.
  • The 2 share lot acquired on 1/03/2011 is considered to be two sublots, each containing 1 share. This is the same idea as branching for wash sales.
  • One carries a cost basis of $100 and an acquisition date of 01/03/2011, the other carries a cost basis of $125 and an acquisition date of 02/15/2011
Example 4 — Long Partial Constructive Sale with Closeout

Activity:
  • The taxpayer buys two shares of stock ABC on September 1st of 2010 for $100 each.
  • On February 15th of 2011, the taxpayer shorts one share of stock ABC at $125.
  • On October 1st of 2011, the taxpayer sells one of the shares from the September 1st purchase at $130.
  • The other positions remain open at year end, December 31st 2011.
Long Partial Constructive Sale with Closeout
Event Date Investment Quantity Event Type Total Amount
09/01/2010 ABC 2.00 Buy 200
02/15/2011 ABC -1.00 Short Sell -125
10/01/2011 ABC -1.00 Sell -130

Result:
  • First, the taxpayer breaks the original September 1st buy into 2 sublots of 1 share each.
  • The short on February 15th is a crossing transaction. Now in processing the October 1st sell, the taxpayer has two options: a more-tax option and a less-tax option.
  • More-tax Option for Example 4
    On October 1st, decide that we are selling the constructively sold shares. On October 1st, the taxpayer sells the sublot that he identifies as the shares constructively sold on February 15. These shares have a previously recognized short-term gain of $25, with a previously adjusted basis of $125 and an apparent tax date of February 15th. (However, per the straddle rules, the holding period of the long position does not begin until the short position is disposed of. See Tax Implications of Straddles).

    When these shares are sold on October 1st, the sale generates an additional short-term gain of $5. Additionally, the crossing shares (the short from February 15) still remains and now causes a constructive sale of the unsold sublot. These newly constructively sold shares have an adjusted basis of $130 and a tax date of October 1st, with a realized short-term gain of $30. In sum, the taxpayer has $60 of short-term gain, and a long position with an apparent date of October 1st of 2011. (However per the straddle rules, the holding period of the long position does not begin until the short position is disposed of.

  • Less-tax Option for Example 4
    On October 1st, decide that we are selling the shares that were not constructively sold. On October 1st, the taxpayer sells the sublot that is not part of the constructive sale created on February 15. These shares, which have an adjusted basis of $125 and a tax date of February 15th, have a previously recognized short-term gain of $25. On October 1st, the unadjusted sublot is sold, realizing an apparent long-term gain of $30. In sum, the taxpayer has $25 short-term gain and an apparent $30 long-term gain, and a long position dated February 15th of 2011. However, due to straddle rules, the long-term gain may be reclassified to short-term, depending on the straddle treatment applied.

    Example 4 illustrates how important it is for the taxpayer to decide which sublot should be sold after a constructive sale on part of a lot.
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The Tax Code on Constructive Sales

Section 1259 (also known as Constructive Sales Treatment for Appreciated Financial Positions) provides that “(1) In general, a taxpayer shall be treated as having made a constructive sale of an appreciated financial position if the taxpayer (or a related person)

  1. enters into a short sale of the same or substantially identical property,
  2. enters into an offsetting notional principal contract with respect to the same or substantially identical property,
  3. enters into a futures or forward contract to deliver the same or substantially identical property
  4. in the case of an appreciated financial position that is a short sale or a contract described in subparagraph (B) or (C) with respect to any property, acquires the same or substantially identical property, or
  5. to the extent prescribed by the Secretary in regulations, enters into 1 or more other transactions (or acquires 1 or more positions) that have substantially the same effect as a transaction described in any of the preceding subparagraphs.
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Constructive Sale Concepts

Tax practitioners and compliance officers need to understand the Crossing Transactions concept as well as the two exceptions to Section 1259 in order to accurately apply the constructive sale rule to securities transactions.

Crossing Transactions

The tax code lists transaction types that can cause a constructive sale. We call these "Crossing Transactions." We believe our term conveys more meaning. A Crossing Transaction is a transaction that appears to invoke the constructive sale rule. The transaction must be on the same or substantially identical property or a stand-in transaction for the same or substantially identical property. Only once you determine whether the exceptions are satisfied will you know if the Crossing Transaction has instigated a box and a constructive sale must be recognized.

Exceptions

Section 1259 allows for two exceptions -- Closed Transaction Exception and Serial Hedge Exception -- in which investors do not have to pay capital gains.

The Closed Transaction Exception 1259(c)(3)(A), applies when all of the following conditions exist for a pair of trades:

  1. The transaction that would have created the constructive sale is closed before the end of the 30th day after the end of the tax year.
  2. The appreciated financial position was held throughout the 60-day period beginning on the date on which the transaction closed.
  3. The risk of loss was not reduced at any time during that 60-day period by holding certain other positions.

The Serial Hedge Exception 1259(c)(3)(B), applies when all of the following conditions exist for a pair of trades:

  1. This risk reduction position is closed before the 30th day following the end of the tax year.
  2. Leg-1 continues to remain open for 60 days after the risk reduction position is closed.
  3. No new risk reduction transaction occurs during the 60 days unless it also meets these criteria.
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History of Constructive Sale Rule

In an effort to help balance the federal budget, President Bill Clinton signed the Tax Relief Act 1997 (TRA), which introduced sweeping tax cuts and identified and disallowed constructive sales. The constructive sale rule is meant to do two things:

  1. stop investors from avoiding capital gains taxes on investments gains and
  2. curtail investors from being able to transfer investment gains into future tax periods.

In the 1990s, the use of constructive sales was widespread among hedge funds and affluent investors as a means to reduce, defer or eliminate tax liabilities and take advantage of the fact that short-term capital gains tax rates are far more punitive than long-term tax rates. Hedge funds aggressively used constructive sales to delay those gains from being realized for as long as possible.

High Fashion, High Finance and Tax Fraud
The Estée Lauder Companies are known the world over for skin care, makeup, fragrance and hair care products for men and women alike. Aside from being associated with glamorous shades of lipstick and exotic perfumes, the Lauder family is also known for its shrewd understanding and manipulation of the U.S. Tax Code. Back in 1995, when the company issued an Initial Public Offering (IPO), Estée Lauder, the family matriarch, and her son, Ronald, attempted to avoid paying a whopping $95 million in capital gains taxes on the profits they reaped when they sold company stock. How did they do this? They created a constructive sale.

When their company went public, they did not sell their own stocks but instead, borrowed company stock from other family members and sold those shares. This created a constructive sale or a ‘short-versus-the-box,’ whereby both a long and a short position are held at the same time. Within two years of the Lauder transaction, which drew a great deal of negative press and ire from the IRS, the TRA shut down the constructive sale loophole.

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Resources on Constructive Sales
White Papers about Constructive Sales

Constructive Sales This paper discusses the history and applications of Section 1259, the Internal Revenue Code (IRC) that governs tax treatment for constructive sales. In addition to addressing how to identify constructive sales, the paper also discusses other important topics, including the similarities between cost basis adjustments for constructive sales and wash sales. Examples are included.

Advanced Topics in Constructive Sales: The Exceptions This paper discusses two key exceptions to the Constructive Sale rule — the Closed Transaction Exception and Serial Hedge Exception — and uses many examples to show how to interpret and implement them when calculating realized gains & losses on investment portfolios.

Tax Implications of Straddles This paper discusses two issues integral to cost basis calculations: (1) how to calculate taxable gains and losses for straddles transactions, per Section 1092 of the tax code, and (2) how to account for the effects of other taxable events, such as wash sales, on straddles and vice versa. Examples are included.

This is relevant to the understanding of constructive sales because most constructive sales will also trigger a straddle.

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Webinars on Constructive Sales
  • Wash Sales, Constructive Sales & Straddles: A Primer This webinar provides an overview of the aforementioned taxable events (Sections 1091, 1259 and 1092 of the IRC) and how they affect realized gains & losses.

  • Constructive Sales: The Exceptions This advanced webinar covers two key exception rules to the Constructive Sale rule — the Closed Transaction Exception and Serial Hedge Exception — and uses examples to show how to interpret and implement these exceptions when calculating realized gains & losses on investment portfolios.
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Video Clips on the Constructive Sale Rule
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IRS & Legal Information Institute (LII) Resources on Constructive Sales

Click here to access Pub 550, the IRS publication that provides information and guidance on complying with sections of the Internal Revenue Code (IRC) that pertain to investment income and expenses.

To read specifically about constructive sales as described in Pub 550, click here.

Another useful on-line resource to research different sections of the IRC is the Legal Information Institute (LII) site, which is published by Cornell University Law School.
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