Last week we reviewed how the constructive sale rules actually work. If you missed last week's article, go back and check it out. We also introduced the exceptions to the constructive sale rules. This week we'll look at the exceptions in much more detail.
The Exceptions
As we noted last week, you are NOT required to treat a transaction as a constructive sale if ALL of the following are true:
1. You closed the transaction before the end of the 30th day after the end of your tax year.
2. You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
3. Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.
In other words, you are required to ignore the constructive sale rules if you close the offsetting position prior to January 30th of the following tax year, and you retain your original position for at least 60 days after closing the offsetting position. In addition, you are prohibited from entering into any other type of offsetting position for that same 60-day period.
If you reread Examples 1 and 2 in Part II of this series, you'll see the statement "you made no other transactions in the stock for the rest of 1999 and the first 30 days of year 2000." You should now see the importance of this statement. If the proper moves are made, you can overcome the constructive sale rules. So let's see how the constructive sale rules work in real life.
Example #1: On May 1, 1999, you bought 100 shares of ABC Corporation stock for $1,000. On September 3, 1999, you sold short 100 shares of ABC stock for $1,600. You held both of these positions until January 10, 2000. On that date, you close your offsetting short position for $1,800 and you keep your "long" position open until at least March 11th (at least 60 days). And, during that time, you did not enter into any other offsetting positions that would have reduced your risk of loss on your original position. Since you have met all of the exceptions to the constructive sale rules, you have no constructive sale for 1999. When you close your short position on January 10th, you'll recognize a short-term capital loss of $200 in tax year 2000. Your cost basis for your long position will remain $1,000, but your holding period will move to January 10, 2000.
Example #2: On May 1, 1999, you bought 100 shares of ABC Corporation stock for $1,000. On September 3, 1999, you sold short 100 shares of ABC stock for $1,600. You held both of these positions until January 10, 2000. On that date, you close your offsetting short position for $1,800. But, because of the fluctuations in the stock, you sell your long position on March 1st (well before your required holding date of March 11th) for $1,500. You have now violated the exceptions to the constructive sale rules, and you must recognize the constructive sale of the original position back in 1999 (when the constructive sale actually took place), and not in year 2000 when you actually sold the stock.
In 1999 you'll recognize a short-term gain of $600 because of the constructive sale, and your basis in the stock would be $1,600. When you actually sell your original position on March 11th for $1,500, you'll recognize a $100 short-term loss (since your basis in the original shares was $1,600 and you made the sale for $1,500). In addition, you'll also be required to recognize a short-term loss of $200 in year 2000 on the short position that you closed in that year. In effect, because of the timing of the transactions and the fluctuations in the stock prices, you'll pay tax on $300 in capital gains that you never really received. In fact, if you track the actual cash received on all of these transactions, you'll find that you are required to realize a net capital gain (over both years) of $300, but you actually lost $1,000 in real cash dollars on these convoluted transactions.
One very important thing that you should remember: Once you meet the constructive sale rules exceptions, you are then allowed (should you desire) to enter into ANOTHER offsetting position. But you'll have to be sure that you meet the exceptions for the NEW offsetting position.
Let's go back to Example #1. Since you met the exception for 1999, anytime after March 11, 2000, you can again "short against the box" on your long position. But to avoid constructive sale recognition for year 2000, all of the requirements must be met. And you must make sure that you wait until after the 60-day "waiting period" has passed before entering into another offsetting position. Exception number three requires the waiting period.
Confusing? You bet. It can get very, very complicated. And, we have really only scratched the surface here, but this is certainly something that you need to understand should you decide that you want to "hedge" some of your stock positions.
Next week we'll look at some of the other rules regarding constructive sales, and we'll also talk about how using options may or may not trigger the constructive sale rules. But if you can't wait for next week's installment, you can always read more about constructive sales in IRS Publication 550 at the IRS website.
Related Links:
The Constructive Sale Rules Series 1 - 4
Constructive Sales: The Rules - Part I
Constructive Sales: The Rules - Part II
Constructive Sales: The Exceptions - Part III
Constructive Sales: Special Transactions - Part IV
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- July 23, 1999
