Tax Planning Using the Constructive Sale Rules – When is a constructive sale not a constructive sale?
By Ted Dougherty and Lisa Sergi
Notwithstanding strong headwinds in the financial markets, a number of hedge funds are sitting on large unrealized gains in their portfolios. Concerns arising from the outcome of elections in the United States, Brexit, and other geopolitical forces may prompt some hedge funds to move to reduce their exposure. Affirmative use of the “constructive sale rules” may allow a fund to hedge an appreciated position through the end of the year without recognizing the gain for tax purposes.
The constructive sale rule was enacted in 1997 with the specific purpose of eliminating what Congress perceived to be an abusive transaction – the so-called “short against the box.”1 In that strategy, a taxpayer with an unrealized gain in an equity position would enter into a short position in the same security. If that short was done in a separate brokerage account, and both the long and short positions remained open, there was no taxable event even though the original position was fully hedged. The constructive sale rule effectively eliminated the ability to fully hedge an appreciated position.2
Operation of the Constructive Sale Rule
The constructive sale rule operates to trigger recognition of a gain for tax purposes where the taxpayer holds an appreciated financial position and enters into one of several enumerated offsetting transactions. An appreciated financial position includes any position with respect to stock, debt or a partnership interest if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. There are exceptions for certain debt instruments, and the rules do not apply where the position is subject to mark to market rules. The term position itself means any interest including a futures or forward contract, short sale, or option.
A taxpayer is treated as having entered into a constructive sale of an appreciated financial position if the taxpayer or related person:
- Enters into a short sale of the same or substantially identical property,
- Enters into an offsetting notional principal contract (generally, a swap) with respect to the same or substantially identical property,
- Enters into a future or a forward contract to deliver the same or substantially identical property,
- In the case of an appreciated financial position that is a short sale or contract described above with respect to any property, acquires the same or substantially identical property, and
- Other transactions that have substantially the same effect as the transactions described above as provided in regulations to be issued by the Treasury (to date no such regulations have been issued).
What is noticeably missing from this list is option transactions. Under current law, a short call option or a long put option may mitigate the risk of holding a long position but would not trigger a constructive sale. However, the legislative history that led to the enactment of the constructive sale rule suggests that a transaction involving both a short call and a long put (a so-called “collar” transaction) would create a constructive sale if the transaction removed substantially all opportunity for gain and risk of loss.
The Exception to the Constructive Sale Rule
So how do you hedge against your down side risk during these uncertain times? The good news is that there is an exception to the constructive sale rules that allow an investor to do just that, without triggering gain and associated tax.
In effect the constructive sale rules do not apply if:
- The transaction which triggered the operation of the constructive sale rule to begin with is closed during the taxable year, or on or before the 30th day after the close of the taxable year,
- The taxpayer continues to hold the original appreciated financial position for a 60-day period that begins on the date the offsetting position has been closed, and
- At no time during that 60-day period does the taxpayer hedge such appreciated financial position.3
If these three criteria are met, then the transaction is treated as if a constructive sale never occurred. A hedge fund that is concerned about market uncertainties during this fourth quarter may enter into an offsetting position to hedge an appreciated position without recognizing taxable gain on the transaction. As long as the fund unwinds the offsetting position by January 30, 2017, and meets the other requirements set forth above, there is no constructive sale.
A few important things to note:
While not entirely clear, it appears that the holding period of the appreciated financial position may be impacted even if there is no taxable constructive sale. Because the temporary constructive sale also creates a straddle (if the property is “personal property” under the straddle rules), the straddle rules impact the holding period.
Generally, if a taxpayer creates a straddle and the original (appreciated financial) position was held for less than a year, the holding period restarts when the offsetting position is closed. However if the original appreciated financial position was held for the greater than a year, the holding period does not restart but is simply suspended until the offsetting position is removed. Therefore, care should be taken in affirmatively using the exception to the constructive sale rules for taxpayers that want to try to preserve long-term capital gains; in other words, the fund may not want to rely on the exception to the constructive sale rules with respect to any positions that are approaching long-term holding period status because the holding period may restart after the constructive sale is closed.
In addition, the unwinding of the transaction that caused the constructive sale will result in a gain or loss for tax purposes on that transaction. A gain would be recognized in the year in which it is unwound, and a loss would be deferred under the straddle rules until the original position was closed.4
The No-Hedging Rule
The rule which requires the taxpayer to remain unhedged for a 60-day period after closing the constructive sale transaction is broader than the actual constructive sale rules. As noted above, the test for whether a constructive sale has occurred looks to whether the offsetting position is substantially identical to the original appreciated financial position. The hedging rule is much broader because it is defined by reference to the straddle rules – so essentially anything that creates a straddle would be deemed to be a hedge, and would disqualify the taxpayer from meeting the exception to the constructive sale rule. For example, a long put transaction, or a written call option that does not meet the qualified covered call exception contained in the straddle rules, would be enough to disqualify the taxpayer from meeting the constructive sale exception.
In summary, hedge funds seeking to preserve gains in the face of fourth quarter financial uncertainty may do so in a tax efficient manner without running afoul of the constructive sale rules. The fund will have until January 30, 2017, to decide whether to unwind the transaction that created the constructive sale, and if it remains unhedged for the following 60 days, the unrealized gain will continue be deferred for tax purposes.
1 The constructive sale rule was enacted as Internal Revenue Code Section 1259, as part of the Taxpayer Relief Act of 1997.
2 The rule only applies to transactions entered into after the effective date in 1997, so it is entirely conceivable that some hedge funds are still sitting on open short against the box transactions some 19 years later.
3 The use of the term “hedge” here is meant to describe a transaction which mitigates the risk of loss of holding a position. Hedge funds should consult their tax advisors on the specific hedging transactions that would be risk-mitigating under this standard.
4 The various straddle identification rules are outside the scope of this discussion.