The evolution of the financial system in the United States — as well as the growing ubiquity of financial derivatives and hedging strategies — has created the need for a federal tax code that is likewise able to evolve. One such evolution found in the Taxpayer Relief Act of 1997 is the constructive sale rule, which essentially removed certain opportunities for savvy investors to avoid taxation. Specifically, the constructive sale rules curbed the practice of hedging appreciated financial positions (AFPs) in an attempt to “lock in” capital gains without triggering a realization event.
While these rules were a necessary addition to the Internal Revenue Code, for taxpayers with intricate risk mitigation strategies they also offer ambiguity and complexity surrounding what constitutes a constructive sale, and they introduce new operational challenges.
What Life Was Like Before the Constructive Sale Rules
Prior to the implementation of the constructive sale rules, a taxpayer with a long AFP could have effectively guaranteed an eventual economic gain by entering into a short position on substantially identical property offsetting the appreciated long position; or conversely, entering into a long position offsetting an appreciated short position. Because the taxpayer then held two positions with diametrically opposed risk characteristics, the taxpayer could have guaranteed the eventual realization of the unrealized gain created by the AFP, as long as both the long and the short position remain open. If the value of the stock in question rose, the taxpayer would recognize no true economic gain or loss, as the values of the two positions would rise or fall inversely. The same is true for any drops in the value of the stock in question — no gain or loss would occur as a result of this movement. However, since there was no recognition event for tax purposes (generally speaking, a recognition event would be triggered upon disposition), the taxpayer was able to defer the capital gains tax on this “gain” until the appreciated position was disposed.
How the Constructive Sale Rules Work
The constructive sale rule attempted to close this risk mitigation loophole, requiring taxpayers to recognize a realized gain at the moment into which a constructive sale is entered. Practically speaking, this recognition event is deemed to occur on the day the second leg of the constructive sale is opened.
Upon entering into a set of transactions constituting a constructive sale, a taxpayer will recognize a gain equivalent in amount and character to the gain that would have been recognized had the taxpayer sold or otherwise terminated at its fair market value the AFP in question. The taxpayer should then be prepared to adjust the cost basis of the AFP in the amount of the gain recognized, and restart the holding period of the AFP as if the position were acquired or otherwise opened on the day of the constructive sale gain recognition.
Implementation and Operational Challenges of the Constructive Sale Rules
There are numerous challenges that taxpayers and practitioners alike face in implementing the constructive sale rules. Primary among these challenges is the inherent ambiguity in determining what constitutes a position that is “substantially identical” to the AFP. A long equity position and a short on the same equity would clearly constitute offsetting positions in substantially identical property, but consider a few less obvious examples:
- Would a corporate bond and a short equity position issued by the same corporation as the bond constitute opposing substantially identical positions?
- How about a short S&P 500 future against an S&P index tracking ETF?
- What about a collar strategy, in which a taxpayer buys protective puts and writes calls on an underlying stock?
Taxpayers with short exposure of any kind within their investment portfolios should be prepared to answer these questions to appropriately identify the population of potential constructive sales that may be triggered.
In addition to the challenges posed in determining whether two or more positions are deemed to create a constructive sale, taxpayers and practitioners should be prepared to deal with the operational challenges posed by the constructive sale rules. Once a constructive sale is created, a taxpayer’s basis and holding period will require adjustment, potentially impacting not only the taxation of the positions in question but also impacting potential wash sales, straddles and qualified dividend income calculations. To further complicate matters, IRC section 1259 includes exceptions to the constructive sale rules, allowing investors who have triggered constructive sales to potentially disregard the gain recognition by adhering to specific rules related to eliminating their mitigation of risk.
Taxpayers with complex investment strategies, particularly those employing intricate risk mitigation or hedging strategies, should be careful to avoid any unintended gain recognition by virtue of the constructive sale rules.
Contact Patrick Grodach at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.