What Is 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."
- The Constructive Sale Rule, Section 1259 of the Internal Revenue Code, expands the types of transactions that are subject to capital gains tax.
- Constructive sales include making short sales against similar or identical positions and entering into futures or forward contracts that call for the delivery of an already-held asset.
- The Constructive Sale rule was instituted to counter hedge funds, which used them to avoid higher tax rates on short-term capital gains.
Understanding 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, there is an exception for any transaction which would otherwise cause a constructive sale during the taxable year if such transaction is closed on or before the 30th day after the close of such taxable year, and if the taxpayer holds the appreciated financial position throughout the 60-day period beginning on the date such transaction is closed. If all of these conditions are met, 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.