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[[I have been reading your series of articles with interest regarding realized gains,
e.g. shorting the box, buying a put against a position, etc. all cause a realized

I hope that you have enjoyed the series.

[[ Now I have a question on the concept of a "substantially equal security" ---
particularly as it realates to arbitrage plays --- ]]

And I discuss some of those issue in Part IV of my series. There are a lot of complicated issues out there...and the IRS has not provided any quidance. So it can get pretty dicey.

[[let's say that A is buying B on a
one-to-one basis; I buy 1000 shares of B and either 1. sell short 1000 shares of
A or 2. buy 10 put contracts on A; obviously & fully intending to make money
on the spread between A & B at no risk to me other than the potential that the
deal between A & B falls apart. Assuming that the deal remains open through a
year-end; have I realized a gain buyt selling a substantially equal security???

I personally think the answer is no, because of the continuing risk that A may not
buy B until such time as the deal is approved by both sets of shareholders or
maybe not until actualization of the sale & exchange of shares; however, I am
admittedly unsure.]]

I'll tell you what...I am equally unsure. And I will remain unsure until the Treasury give us regulations on this issue. But instead of pontificating, and since you have been a long and distinguished member of the Tax Strategies message folder community, I'm going to give you a sneak preview of Part IV of the series. I think that it may help to answer your question.
Constructive Sales - Finis

In the last three weeks we've discussed various issues regarding the new constructive sales rules. If you've missed those articles, you might want to take the time and read them…just to get up to speed.

Moving forward, there are still a few items to review. While we have focused on the "short against the box" strategy in prior articles, there are other ways that a "long" position can be hedged. Many investors use other transactions in order to hedge their positions. And the question then becomes: "Do the constructive sale rules impact the use of these other financial transactions to hedge a position?" The answer is no. Or yes. Or even maybe. I guess the best answer is: It all depends.

I'm personally waiting for the regulations from IRS on this very issue. Those regulations will address these issues and how they relate to constructive sales. They'll also likely provide specific examples for various financial transactions. But as of this date, those regulations are still not published. So, since the regulations are not yet available, the best source of information would be the General Explanation of Tax Legislation (commonly referred to as the "Blue Book"), which was prepared by the Staff of the Joint Committee on Taxation in consultation with the staffs of the House Committee on Ways and Means and Senate Committee on Finance. If you are really interested in this subject, you should read then entire text at:
(You'll want to look for the 1997 Joint Committee on Taxation Blue Book--General Explanation of Tax Legislation Enacted in 1997, JCS-23-97, December 17, 1997). It's some long reading, but you should be able to find the appropriate section (Part II, Title X, under the heading "Revenue Increase Provisions).

Special Transactions

Remember that the constructive sale rules were implemented to stop transactions that had the effect of eliminating substantially all of your risk of loss AND opportunity for income and gain with respect to the appreciated financial position. That's the standard and it's very clear. Applying this reasoning, the Congress intended that transactions that reduce ONLY risk of loss or ONLY opportunity for gain would NOT be covered under the constructive sale rules.

Example: You hold an appreciated financial position in stock. You then enter into a "put" with an exercise price equal to the current market price (an "at the money" option). Because such an option reduces ONLY your risk of loss, and not your opportunity for gain, the above standard would not be met, and this would NOT be considered a constructive sale transaction. Again, remember that the transactions that the constructive sale rules impact are those that reduce BOTH risk of loss AND opportunity for gain. So if you hedge only one end of the transaction, the constructive sale rules wouldn't apply.


But there are other financial positions that may be impacted. One of them would be what is commonly called a "collar". In a collar, you commit to an option that requires you to sell a financial position at a fixed price (the "call strike price") and have the right to have your position purchased at a lower fixed price (the "put strike price").

Example: You enter into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the transaction is that you have transferred the rights to all gain above the $110 call strike price and all loss below the $95 put strike price. But…you have retained all risk of loss and opportunity for gain in the price range between $95 and $110. A collar can be a single contract or can be effected by using a combination of put and call options. So while your gain AND loss is eliminated above $110 and below $95, your gain OR loss is alive and well between those two prices. Constructive sale?

Based upon what we know, it's difficult to say if a collar will be treated as a constructive sale. The Congress anticipates that Treasury regulations will provide specific standards that take into account various factors with respect to the appreciated financial position, including its volatility. You can certainly expect that the regulations will review several aspects of the collar transaction. Important issue will include the spread between the put and call prices, the period of the transaction, and the extent to which the taxpayer retains the right to periodic payments on the appreciated financial position (such as the dividends on collared stock). So is YOUR collar (which may be substantially different that mine) a constructive sale? That's up to you, your God, and the IRS (and likely your tax pro)...and your collective interpretation of the IRS code. And this is one of the reasons that we are waiting for the regulations.


Another common transaction for which regulations would be helpful is a so-called "in-the-money" option. That would be a put option where the strike price is significantly above the current market price or a call option where the strike price is significantly below the current market price.

Example: You purchase a put option with a strike price of $120 with respect to stock currently trading at $100. You have eliminated all risk of loss on the position for the option period. You may have also effectively transferred substantially all of the potential gain on the stock because only if its value rises above $120 can there be any gain to you. Constructive sale?

We'll have to wait for the regulations. I suspect that they will provide a specific standard that takes into account many of the factors described above with respect to collars, including the yield and volatility of the stock and the period and other terms of the option.

Other Transactions

For collars, options and some other transactions, one approach that the IRS might take in issuing regulations is to rely on option prices and option pricing models. The price of an option represents the payment the market requires to eliminate risk of loss (for a put option) and to purchase the right to receive yield and gain (for a call option). Thus, option pricing offers one model for quantifying both the total risk of loss and opportunity for gain with respect to an appreciated financial position, as well as the proportions of these total amounts that the taxpayer has retained.

In addition to setting specific standards for treatment of these and other transactions, it may be appropriate for Treasury regulations to establish "safe harbor" rules for common financial transactions that do not result in constructive sale treatment. An example might be a collar with a sufficient spread between the put and call prices, a sufficiently limited period and other relevant terms such that, regardless of the particular characteristics of the stock, the collar probably would not transfer substantially all risk of loss and opportunity for gain. But only time will tell what the Treasury will place in the regulations. Again, that is why these regulations (and the guidance that they'll provide) are desperately needed.

The good news: it appears that whatever regulations are written, they will be prospective and NOT retroactive. So if you (or your tax pro) determines that one of your transactions is not a constructive sale, but the regulations (when finally issued) say that it is, you may very well be off the hook. It may not require a restatement of your transaction, or an amended return (if the transaction took place in a prior year). I would anticipate that the only regulations that would be applied retroactively would be those necessary to prevent abuse.

Again, the entire constructive sale issue is very complicated…potentially one of the most complicated tax issues since the passive loss rules. If you are non-Foolish, and use a bunch of financial transactions in order to hedge your various stock positions, you had better become very well versed in the constructive sale rules. It'll certainly complicate your life. And while you are waiting for the regulations, you had better at least read IRS Publication 550 and the section in that Publication on the constructive sale rules.

But for Fools, simple buy and hold investors who don't try to guess the market and hedge transactions, these complicated tax issues have no meaning whatsoever. They simply won't apply to you…and you can effectively ignore them. And that should give you much more time to spend with your family and friends…rather than with brokerage statements and tax codes and regulations. And isn't that what Foolishness is really all about?

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