DEFINITION of Constructive Sale Rule, Section 1259

The Constructive Sale Rule, Section 1259, is a section of the Internal Revenue Code that expands the types of transactions that are considered to be sales and are subject to capital gains tax. According to this rule, transactions that effectively take an offsetting position to an already owned position are considered to be constructive sales. The purpose of the constructive sale rule is to prevent investors from locking in investment gains without paying capital gains and to limit their ability to transfer gains from one tax period to another.

This rule is Section 1259 of the tax code. It is also referred to as "Constructive Sales Treatment for Appreciated Financial Positions."

BREAKING DOWN Constructive Sale Rule, Section 1259

This rule was introduced by Congress in 1997. Transactions considered to be constructive sales include making short sales against similar or identical positions (known as "short sales against the box") and entering into futures or forward contracts that call for the delivery of an already-held asset.

There are some exceptions to the rule that remove the need to pay capital gains. For example, if the transaction is closed prior to 30 days after the end of the year in which the gain was achieved, or if the original position is held for 60 days after the offsetting position is closed, then no capital gains tax will be incurred.

It is possible for constructive sales to have a type of cascade effect where the closure of the position sets off a subsequent constructive sale. Under certain circumstances, such as when the crossing position remains open when a constructive sale occurs, yet another sale can be set off. That would require yet another appreciated position to be in place.

Why the Constructive Sale Rule Was Established

Prior to this rule, there were rampant constructive sales, particularly by hedge funds, as a way to remove tax liabilities by stalling the realization of gains on sales. This was to avoid the higher tax rates on short-term capital gains.

For example, without the rule, prominent shareholders in a family-controlled company about to go public might borrow shares from their relatives to be sold in a constructive sale while maintaining their own shares. That would allow them to maintain short and long positions simultaneously. Such a practice was employed by members of the Lauder family when Estée Lauder Companies went public in 1995 in order to avoid paying taxes. With the Constructive Sale Rule in place, this practice was put to an end.