DEFINITION of 'Constructive Sale Rule - Section 1259'

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 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 the crossing position remaining 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 the 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 Estee Lauder Companies went public in 1995 in order to avoid paying taxes. With the constructive sale rule in place, the practice was put to an end.

RELATED TERMS
  1. Section 1244 Stock

    A type of equity named after the portion of the Internal Revenue ...
  2. Construction Interest Expense

    Construction interest expense is interest that accumulates on ...
  3. Construction Spending

    Construction spending is an economic indicator that measures ...
  4. Attribution Rules

    A set of rules created by Canada Revenue Agency (CRA) that prevents ...
  5. Rule Of 70

    A way to estimate the number of years it takes for a certain ...
  6. Private Letter Ruling - PLR

    A private letter ruling is an IRS interpretation of rules and ...
Related Articles
  1. Taxes

    How The Straddle Rule Creates Tax Opportunities For Options Traders

    This rule allows traders to substantially reduce their risk, and possibly benefit on their tax returns as well.
  2. 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.
  3. Taxes

    How Are Futures & Options Taxed?

    We present a basic introduction to the US tax processes of futures and options.
  4. Financial Advisor

    Indie BDs: Trump Should Drop the Fiduciary Rule

    A majority of independent broker-dealers want Trump to repeal the fiduciary rule, a recent survey reveals.
  5. Financial Advisor

    How Trump Could Repeal, Soften Fiduciary Rule

    Donald Trump has threatened to repeal the new fiduciary rule. Here’s what he could do if he wants to kill the rule in its present form.
  6. Taxes

    Use Tax Vs. Internet Sales Tax: How Are They Different?

    Learn about the differences between a use tax and an Internet sales tax. Find out about transactions in which the taxes apply, and to whom they apply.
  7. Personal Finance

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
  8. Taxes

    Internet Sales Tax Vs. Brick & Mortar Sales Tax

    Learn about the differences between sales taxes and Internet sales taxes, and the goods and services that typically incur each type of tax.
  9. Investing

    The Tax Consequences of Having Multiple Managers

    Having multiple firms or advisors manage your investments could result in adverse tax consequences.
  10. Taxes

    Do You Have to Pay Taxes on Home Sales?

    Taxes are only paid on home sales if your proceeds exceed a certain amount.
RELATED FAQS
  1. What kinds of restrictions does the SEC put on short selling?

    Learn about the rules and regulations on short selling enforced by the U.S. Securities and Exchange Commission, or SEC, including ... Read Answer >>
Hot Definitions
  1. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  2. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  3. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  4. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  5. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
  6. Hedge Fund

    A hedge fund is an aggressively managed portfolio of investments that uses leveraged, long, short and derivative positions.
Trading Center