§1260 Gains From Constructive Ownership Transactions

Summary

If you make money from a deal that gives you the economic benefits of owning a financial asset, and that gain would normally be a long-term capital gain, part of it must be taxed as ordinary income. The part taxed as ordinary income is whatever amount is larger than the “net underlying long-term capital gain.” Any remaining gain is still long-term capital gain, and the tax rate on that part is figured using the same rate that would apply to the net underlying long-term capital gain. If any gain is reclassified as ordinary income, you also owe interest for earlier years while the deal was open. That interest is calculated as if the gain had been earned evenly over the open period at the applicable Federal rate in effect when the deal closed. The interest stops accumulating on the due date (without extensions) for the tax return for the year the deal closed. The added tax cannot be used to get tax credits or to change alternative minimum tax calculations. Short definitions and rules: a “financial asset” means an ownership interest in a pass‑through entity and, by rule, may include debt or corporate stock. A “pass‑through entity” covers things like regulated investment companies, REITs, S corporations, partnerships, trusts, common trust funds, PFICs, and REMICs. A “constructive ownership transaction” includes long positions under notional principal contracts, forward or futures contracts to buy the asset, holding a call and selling a put with similar strike and dates, or other deals the tax agency treats the same way. The rule does not apply if all positions are marked to market under tax rules. “Net underlying long-term capital gain” means the gain that would have happened if you had bought the asset at fair market value when the deal opened and sold it at fair market value when it closed; it is treated as zero unless clearly and convincingly proven. If the deal ends because you take delivery, the tax is worked out as if you sold the contracts at fair market value on the closing date, and the Treasury can make rules to let taxpayers mark to market or to exclude certain forward contracts.