§1258 Recharacterization of gain from certain financial transactions

Summary

When a profit would normally be a capital gain but comes from a “conversion transaction,” part of that profit must be taxed as ordinary income instead of all as a capital gain. The ordinary part equals the “applicable imputed income amount,” which is the interest that would have built up on your net investment in the deal up to the sale (or until the deal stopped meeting the rules) at a rate equal to 120 percent of the applicable rate, minus any amount already treated as ordinary income from earlier sales of parts of the same deal. A “conversion transaction” is any deal where most of the expected return comes from the time value of your money in the deal. That covers holding property with a near‑time sale contract, an applicable straddle, transactions sold as producing capital gains from time-value returns, or other transactions listed in regulations. The “applicable rate” is the Federal rate under section 1274(d) (compounded semiannually) if the deal looks like debt, or the short‑term Federal rates under section 6621(b) (compounded daily) if the deal has no fixed term. If a position with a built‑in loss becomes part of a conversion, it is valued at fair market value when it joined the deal for later tax rules, but that built‑in loss is recognized later when the position is sold. The rule does not apply to options dealers or commodities traders acting in the normal course of their businesses, but it can still apply to limited partners or similar investors if most of their expected return comes from time value, the interest was marketed as producing capital gains from such a transaction, or the transaction is listed in regulations.