Constructive Sale

Ignatius Bramwell has held 5,000 shares of Corriente Industries for six years and has a large unrealized gain. Hoping to lock in the gain without triggering tax in the current year, he borrows 5,000 identical shares and sells them short, leaving both the long position and the short position open past December 31. Under IRC Section 1259, what is the consequence?

1. A.No gain is recognized until he actually delivers the long shares to close out the short position.Wrong. That was the pre-1997 result. Section 1259 accelerates recognition to the date the offsetting position is opened.
2. B.The gain is recognized, but Section 1259 converts it from long-term to short-term.Wrong. The gain is recognized at its existing long-term character; the provision changes timing, not character.
3. C.The short sale is a constructive sale of the appreciated position, so he must recognize the gain as if he had sold the long shares on the date the short was established.Correct. That is precisely the constructive sale rule of Section 1259.
4. D.The transaction is a wash sale, so any resulting loss is disallowed and added to basis.Wrong. The wash sale rule addresses losses; this position holds a gain, and the applicable provision is the constructive sale rule.

Why: Section 1259 treats certain transactions that eliminate substantially all of an investor's risk of loss and opportunity for gain in an appreciated financial position as constructive sales. Selling short the same stock the taxpayer already owns, the classic short against the box, is the leading example. The gain on the long position must be recognized as though the shares had been sold on the day the short position was established, and the holding period resets from that date. The strategy still works as a hedge; it simply no longer defers the tax, which was the entire reason the provision was enacted.

Elena has a large unrealized gain in Vantage Corp stock she has held for three years. In December she sells short an equal number of Vantage shares, planning to keep both positions open into the following year. Under the constructive-sale rules, what is the likely tax result?

1. A.The gain remains deferred until she actually closes the long position.That was the result before the constructive sale rules were enacted. The rules exist specifically to shut down this deferral.
2. B.The short sale is treated as a constructive sale of her appreciated long position, so she must recognize the gain in the current year and the deferral fails.Correct. Offsetting an appreciated position so completely triggers constructive sale treatment and current recognition of the gain.
3. C.No gain is recognized, because she never sold the shares she actually owns.The rules deliberately look past the form of the transaction to its economic substance, which is a completed sale.
4. D.Her holding period restarts, converting a long-term gain into a short-term one.The consequence is timing of recognition, not conversion of character. A three-year holding period still produces long-term treatment.

Why: Selling short an identical number of shares of a stock you already own at a gain removes essentially all of your remaining risk and opportunity. The tax code treats that as a constructive sale of the appreciated position, so Elena must recognize the gain in the current year exactly as if she had sold the shares. The deferral she was hoping for does not happen. Review the constructive sale rules in the taxation topic.