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.

RELATED TERMS
  1. Tax Code

    A tax code is a federal government document that details the ...
  2. Construction Interest Expense

    Construction interest expense is interest that accumulates on ...
  3. Rule Of 70

    The rule of 70 is a means of estimating the number of years it ...
  4. Section 1245

    Section 1245 is a tax law codified in the Internal Revenue Code ...
  5. Building Activity Indicators

    Building activity indicators are economic reports that provide ...
  6. Section 1256 Contract

    Section 1256 Contract is a type of investment defined by the ...
Related Articles
  1. Personal Finance

    Top 5 States For Construction Workers

    If you work in construction, these states may offer the best working conditions for you.
  2. Financial Advisor

    Ready for the Fiduciary Rule? You Should Be

    Despite the opposition it faces, advisors should still plan to comply with the fiduciary rule. Here's why.
  3. Personal Finance

    Getting A Mortgage When Building Your Own Home

    It's much harder to get a loan when you're building a home, not moving into one. Here's where to look and what to expect.
  4. Investing

    The Uptick Rule: Does It Keep Bear Markets Ticking?

    This rule prevents traders from driving stocks down, but its effect on market volatility is debatable.
  5. Investing

    7 Year-End Tax Planning Strategies

    Do you have a capital loss that could be booked and used to offset future tax liabilities? If so, it may be time to sell.
  6. Financial Advisor

    How to Avoid Violating Wash Sale Rules When Realizing Tax Losses

    How to avoid violating the IRS wash sale rules when realizing capital losses in your taxable investment account.
  7. Insights

    The DOL Fiduciary Rule Explained

    The Department of Labor (DOL) fiduciary rule expanded the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA), but was vacated by a Federal ...
  8. Personal Finance

    Top 10 Fastest Growing Industries in the United States

    Six of the 10 fastest-growing industries are directly related to new residential construction.
  9. Insights

    Volcker Rule: How It Will Affect You

    Learn how the Volcker Rule has a limited impact on individual investors but restricts the types of activities in which banks can engage.
  10. Personal Finance

    10 Ways to Improve Cash Flow in Construction

    Here's how improving cash flow in construction requires some sector-specific strategies.
RELATED FAQS
  1. How do construction loans work?

    Construction loans are obtained either by the prospective home owner or the actual builder. There are two types of construction ... Read Answer >>
  2. What is the Rule of 72?

    The "Rule of 72" determines roughly how long an investment will take to double, given a fixed annual rate of interest. It ... Read Answer >>
Trading Center