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Sale or Exchange

  • 7517. How is a shareholder taxed on the sale or exchange of stock?

    • Generally, a shareholder who sells or exchanges stock (other than IRC Section 1202 stock, see Q 7522) for other property realizes a capital gain or loss.1 Whether such gain or loss is short-term or long-term usually depends on how long the shareholder held the stock before selling (or exchanging) it.2 For an explanation of how the holding period is calculated, see Q 699; for the treatment of capital gains and losses, including the lower rates for capital gains, see Q 702.

      Specific circumstances may result in the conversion of what appears to be a long-term capital gain to short-term, short-term capital loss to long-term, capital gain to ordinary income, or the disallowance of a loss. See Q 7507 concerning stripped preferred stock, Q 7616 concerning conversion transactions, and Q 701 concerning sales between related individuals. Also, certain derivative securities transactions may result in a constructive sale (see Q 7617 to Q 7621) with respect to an appreciated stock position, which may result in immediate recognition of gain, and the start of a new holding period. See Q 7525 concerning short sales and Q 7588 concerning futures and forward contracts.

      For an explanation of the rollover of gain into specialized small business investment company stock for tax years prior to 2018, see Q 7520. For an explanation of the 50 percent (or 75 percent or 100 percent) exclusion for gain from the sale of qualified small business stock, see Q 7522.

      Assuming none of the special rules described above applies, when shares of stock are sold, the amount of gain (or loss) is the difference between the selling price and the shareholder’s tax basis in the shares at the time of sale. If the shares are exchanged for property, or for property and cash, the amount of gain (or loss) is the difference between the fair market value of the property plus the cash received in the exchange and the shareholder’s tax basis.3 But if common stock in a corporation is exchanged for common stock in the same corporation, or if preferred stock is exchanged for preferred stock in the same corporation, gain or loss is generally not recognized unless cash or other property is also received; that is, the exchange is taxed in substantially the same manner as a “like-kind” exchange (noting that these Section 1036 exchanges are different from the generally applicable Section 1031 exchange rules, which now only apply to real estate exchanges post-reform).

      The exchange of shares of different corporations and exchanges of common for preferred do not qualify for the general “like-kind” exchange rules, even if the shares are similar in all respects.4 The nonrecognition rules of IRC Section 1036 apply to exchanges of common stock for common stock in the same corporation, even though the shares are of a different class and have different voting, preemptive, or dividend rights.5 For an explanation of “like-kind” exchanges, see Q 712.

      Special rules apply to exchanges of stock made pursuant to a plan of corporate reorganization.6 The IRS has released regulations under IRC Section 358 providing guidance regarding the determination of the basis of stock or securities received in exchange for, or with respect to, stock or securities in certain transactions (see Q 692).7

      If a shareholder’s holdings in a company’s stock were all acquired on the same day and at the same price, the shareholder will have little difficulty in establishing the tax basis and holding period for the shares sold or exchanged. But where the shares were acquired at different times or prices and the shareholder sells less than all of the holdings in the stock, the process becomes more difficult while also becoming more significant. Unless the shareholder can “adequately identify” the lot from which the shares being sold originated, the shares sold will be deemed to have come from the earliest of such lots purchased or acquired (i.e., under a first-in, first-out (FIFO) method).8 For an explanation of how lots can be “adequately identified,” see Q 700 and Treasury Regulation Section 1.1012-1.

      If the stock sold was acquired on the conversion of a market discount bond, a portion of the sales proceeds may have to be treated as interest income (see Q 7648).


      1 .See IRC Secs. 1221, 1222.

      2 .See IRC Secs. 1222, 1223.

      3 .See IRC Sec. 1001.

      4 .IRC Sec. 1036; Treas. Reg. §1.1036-1. See IRC Sec. 1031(a).

      5 .Rev. Rul. 72-199, 1972-1 CB 228. See Treas. Reg. §1.1036-1.

      6 .See IRC Sec. 354.

      7 .See Treas. Reg. §§1.358-1, 1.358-2.

      8 .Treas. Reg. §1.1012-1(c).

  • 7518. What is a demutualization? What is the tax treatment of stock sold by a taxpayer following a demutualization?

    • A “demutualization” occurs when a mutually-owned life insurance company (i.e., a company owned by its policyholders, or “members”) converts into a publicly-owned company (i.e., a company owned by its shareholders). Essentially, the members exchange their rights in the mutual life insurance company (i.e., voting and dividend rights) for shares of stock in the “demutualized” company. Where a taxpayer (trust) was a former policy holder in a mutual life insurance company and received shares of stock when that company “demutualized,” and the taxpayer sold its shares and then reported gain—based on the then prevalent belief that the “basis” of such stock was zero—the U.S. Court of Federal Claims held that the taxpayer was entitled to a refund of tax paid. The court analyzed the application of the “open transaction doctrine” to the transaction, and then determined that because the amount received by the trustee was less than the trust’s cost basis in the policy as a whole, the taxpayer, in fact, did not realize any income on the sale of the shares.1

      For guidance on determining the (1) holding period and (2) capital gain treatment of stock received by a policyholder in a demutualization transaction that does (or does not) qualify as a tax-free reorganization, see CCA 200131028.


      1 .Fisher v. U.S., 333 Fed. Appx. 572, 2008-2 USTC ¶50,481 (Ct. Cl. 2008), aff’d per curiam, 2010-1 USTC ¶50,289 (Fed. Cir. 2009).

  • 7519. What are the basis reporting rules that became effective in 2011? To which types of securities do the new rules apply?

    • Under current law, brokers are required to file with the IRS annual information returns showing the gross proceeds realized by customers from various sales transactions.1 Under EIEA 2008, new requirements were enacted with respect to the reporting of a customer’s basis in securities,2 and new rules were put in place for determining the basis of certain securities subject to the new reporting requirements.3 The reporting requirements and basis rules generally took effect on January 1, 2011.4 Final regulations were released in October 2010.5

      Under Section 6045(g), every broker that is required to file a return from the sale of a “covered security” must now include in the return (1) the customer’s adjusted basis, and (2) whether any gain or loss with respect to the security is long-term or short-term.6

      A “covered security” is any “specified security” acquired on or after the “applicable date” if the security was (1) acquired through a transaction in the account of which the security was held, or (2) transferred to that account from an account in which the security was a covered security (but only if the transferee broker received a statement under Section 6045A).7

      A “specified security” is: (1) any share of stock in a corporation (including stock of a mutual fund); (2) any note, bond, debenture, or other evidence of indebtedness; (3) any commodity, or a contract or a derivative with respect to the commodity (if the Treasury Secretary determines that adjusted basis reporting is appropriate); or (4) any other financial instrument with respect to which the Treasury Secretary determines that adjusted basis reporting is appropriate.8

      The “applicable dates” are as follows: stock in a corporation – January 1, 2011; stock in a mutual fund, or stock acquired in connection with a dividend reinvestment plan – January 1, 2012; any other specified security – January 1, 2013.9 The Service announced, however, that the basis reporting requirement for debt instruments and options was not effective until January 1, 2014.10

      Form 1099-B. Effective after December 31, 2008, EIEA extended the deadline for furnishing information statements to customers from January 31 to February 15.11

      EIEA 2008 also provided new rules for determining the basis of certain securities subject to the new reporting requirements.12 The adjusted basis of any security (other than stock in a mutual fund, or stock acquired in connection with a dividend reinvestment plan) is determined under the first-in-first-out method unless the customer notifies the broker by making an adequate identification of the stock sold at the time of sale.13 For any sale, exchange, or other disposition of a specified security on or after the applicable date, the conventions prescribed by the Treasury regulations for determining adjusted basis (i.e., the first-in-first-out, specific identification, and average basis conventions) must be applied on an account-by-account basis.14 An exception for uncorrected, de minimis errors now applies.15


      1 .See IRC Sec. 6045(a).

      2 .See IRC Secs. 6045(g), 6045(h), 6045A, 6045B, as added by EIEA 2008.

      3 .See IRC Sec. 1012, as amended by EIEA 2008.

      4 .Notice 2009-17, 2009-1 CB 575.

      5 .TD 9504, 75 Fed. Reg. 64072 (Oct. 18, 2010).

      6 .IRC Sec. 6045(g)(3)(A), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      7 .IRC Sec. 6045(g)(3)(A), as added EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      8 .IRC Sec. 6045(g)(3)(B), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      9 .IRC Sec. 6045(g)(3)(C)(iii), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      10 .Notice 2012-34, 2012-1 CB 937.

      11 .IRC Sec. 6045(b), as amended by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      12 .See IRC Sec. 1012, as amended by EIEA 2008; IRC section 6045(g), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      13 .IRC Sec. 6045(g)(2)(B)(i)(I), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      14 .IRC Sec. 1012(c)(1), as added by EIEA 2008; Notice 2009-17, 2009-1 CB 575.

      15 .IRC Sec. 6045(g)(2)(B)(iii).

  • 7520. Prior to 2018, under what circumstances could a taxpayer roll over and, thus, defer gain from the sale of publicly traded securities?

    • Editor’s Note: The 2017 Tax Act repealed IRC Section 1044, which previously allowed taxpayers to roll over (and thus defer recognition of) certain capital gains from the sale of publicly traded securities if the amounts were used to purchase an interest in a specialized small business investment company (SSBIC).  This repeal applies for tax years beginning after December 31, 2017.1

      Prior to 2018, individual taxpayers and C corporations could elect to roll over certain capital gain from the sale of publicly traded securities if the individual or corporation used the amount realized from the sale to purchase common stock or a partnership interest in a specialized small business investment company within sixty days of the sale.2 A specialized small business investment company (SSBIC) is any corporation or partnership that is licensed by the Small Business Administration under Section 301(d) of the Small Business Investment Act of 1958.3 “Publicly traded securities” are securities traded on an established securities market.4

      If the election was made, gain from the sale of the publicly traded securities was currently taxable only to the extent that the amount realized from the sale exceeded the cost of the SSBIC stock or interest.5 IRC Section 1044(a)(2) stated that the cost of the SSBIC stock or interest was to be reduced by any portion of such cost previously taken into account under IRC Section 1044.

      The amount of gain that could be rolled over by an individual in a taxable year was generally limited to $50,000. But the aggregate amount of gain that could be rolled over during a taxpayer’s lifetime was $500,000.6 Thus, a taxpayer who had previously rolled over a total of $475,000 in gain in prior tax years, but who has $50,000 in gain in the current year, would have been limited in the current year rollover to $25,000 of otherwise eligible gain. The $50,000 and $500,000 limits were reduced to $25,000 and $250,000, respectively, for married taxpayers filing separately. In the case of a C corporation, the gain that could be deferred in a taxable year may not exceed $250,000; the total amount of gain that may be rolled over during the corporation’s existence was $1,000,000.7

      A taxpayer’s basis in the SSBIC stock or partnership interest was generally reduced by the amount of gain that was rolled over into the stock or interest. But the basis of any SSBIC common stock was not reduced for purposes of calculating the gain eligible for the 50 percent (or 75 percent or 100 percent) exclusion for qualified small business stock provided by IRC Section 1202 (see Q 7522).8

      The election under IRC Section 1044 had to be made on or before the due date (including extensions) for the income tax return for the year in which the publicly traded securities were sold.9

      Estates, trusts, partnerships, and S corporations were ineligible to roll over gain under this section.10


      1.Former IRC Sec. 1044.

      .IRC Sec. 1044, repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(c)(3), repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(c)(1), repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(a), repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(b)(1), repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(b)(2), repealed by Pub. Law No. 115-97.

      .IRC Sec. 1044(d), repealed by Pub. Law No. 115-97.

      .Treas. Reg. §1.1044(a)-1.

      10 .IRC Sec. 1044(c)(4), repealed by Pub. Law No. 115-97.

  • 7521. What is qualified small business stock?

    • IRC Section 1202 provides for special treatment of qualified small business stock, which generally means stock (a) in a C corporation that is a “qualified small business; (b) that meets the active business requirement (explained below); (c) that was originally issued after August 10, 1993; and (d) (except as otherwise provided) was acquired by the taxpayer at its original issue in exchange for money or other property (not including stock), or as compensation for services to the corporation.1 For the tax treatment of qualified small business stock, see Q 7522.

      An issuing corporation is a qualified small business if it is a domestic corporation with aggregate gross assets of $50,000,000 or less at all times after August 10, 1993. Generally, “aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation. Under certain circumstances, a parent corporation and its subsidiary corporations may be treated as one corporation for purposes of determining a corporation’s aggregate gross assets.2

      As a general rule, stock acquired by the taxpayer will not be treated as “qualified small business stock” if the issuing corporation has directly or indirectly purchased any of its stock from the taxpayer (or a related person) within two years before or after the date of issuance.3 But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed from a taxpayer (or related person) exceeds a de minimis amount of stock only if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of the stock held by the taxpayer and related persons is acquired.4

      Similarly, stock issued by a corporation will generally not be treated as qualified small business stock if the issuing corporation makes a significant redemption of stock or, in other words, redeems stock with an aggregate value of more than 5 percent of the value of all of its stock within one year before or after the date of issuance.5 But an issuing corporation may redeem de minimis amounts of stock without the loss of qualified small business stock treatment. Stock redeemed by an issuing corporation exceeds a de minimis amount only if the aggregate amount paid exceeds $10,000 and more than 2 percent of all outstanding stock is purchased.6

      In addition, the following stock redemptions are disregarded in determining whether redemptions exceed de minimis amounts and will not result in the loss of qualified small business stock treatment: (1) a redemption of stock acquired in connection with the performance of services as an employee or director (or an option to acquire such stock) incident to the seller’s retirement or other bona fide termination of such services; (2) a purchase from a deceased shareholder’s estate, beneficiary, heir, surviving joint tenant, surviving spouse, or a trust established by the decedent or decedent’s spouse, and the purchase is within three years and nine months of the decedent’s death, provided that prior to the decedent’s death, the stock (or an option to acquire the stock) was held by the decedent or decedent’s spouse (or by both), by the decedent and joint tenant, or by a trust revocable by the decedent or decedent’s spouse (or by both); (3) a purchase incident to the disability or mental incompetence of the selling shareholder; or (4) a purchase incident to the divorce (within the meaning of IRC Section 1041(c)) of the selling shareholder (see Q 779). Also, transfers by shareholders to an employee or independent contractor (or beneficiary thereof) in connection with the performance of services are generally not treated as redemptions.7

      Stock acquired through the conversion of qualified small business stock of the same corporation will be considered qualified small business stock held for the same period that the converted stock was held by the taxpayer.8

      In order to satisfy the active business requirement, at least 80 percent of the issuing corporation’s assets must be committed to the active conduct of one or more “qualified trades or businesses,” and the corporation must be an “eligible corporation.”9 (A specialized small business investment company is not subject to this requirement,10 see Q 7520.) A “qualified trade or business” is a trade or business other than one that involves (a) the performance of services in a field where the principal asset of the trade or business is the reputation or skill of one or more employees, such as the fields of law, accounting, performing arts, or athletics; (b) any insurance, banking, financing, leasing, investing, or similar business; (c) any farming business; (d) any mining business for which a percentage depletion deduction is allowed under the IRC; or (e) any business operating a hotel, motel, restaurant, or similar business.11

      Regardless of whether the active business requirement is met, stock will not be treated as qualified small business stock unless the issuing corporation is an eligible corporation. An “eligible corporation” is a domestic corporation other than (a) a domestic international sales corporation (“DISC”) or former DISC; (b) a regulated investment company (“RIC”), a real estate investment trust (“REIT”), or a real estate mortgage investment conduit (“REMIC”); (c) a cooperative; or (d) a corporation that has made an election under IRC Section 936 (relating to the U.S. possession tax credit).12


      1 .IRC Sec. 1202(c)(1).

      2 .IRC Sec. 1202(d).

      3 .IRC Sec. 1202(c)(3)(A).

      4 .Treas. Reg. §1.1202-2(a)(2).

      5 .IRC Sec. 1202(c)(3)(B).

      6 .Treas. Reg. §1.1202-2(b)(2).

      7 .Treas. Reg. §§1.1202-2(c), 1.1202-2(d).

      8 .IRC Sec. 1202(f).

      9 .IRC Sec. 1202(e)(1).

      10 .IRC Sec. 1202(c)(2)(B).

      11 .IRC Sec. 1202(e)(3).

      12 .IRC Sec. 1202(e)(4).

  • 7522. How is qualified small business stock treated for tax purposes?

    • If certain requirements are met, a noncorporate taxpayer (including certain partnerships and S corporations) may exclude from gross income a percentage of any gain from the sale or exchange of qualified small business stock held for more than five years.1 The percentage limits are 50 percent for qualifying stock acquired prior to 2009, 75 percent for qualifying stock acquired in 2009 and before September 28, 2010, under the American Recovery and Reinvestment Act of 2009,2 or 100 percent for qualifying stock acquired after September 27, 2010. This provision providing for 100 percent exclusion was enacted under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010), and was extended by the American Taxpayer Relief Act of 2012 (ATRA).3 The provision was made permanent by the Protecting Americans from Tax Hikes Act of 2015 (PATH). (Note that the percentage exclusion is based on the date of acquisition of the stock and that, for any exclusion to apply, the five-year holding period must be met for the stock.)

      For an explanation of what constitutes “qualified small business stock,” see Q 7521. For the treatment of capital gains and losses, including IRC Section 1202 gain, see Q 702. Special rules provide an increased exclusion of gain from the sale of qualifying empowerment zone stock.4

      The aggregate amount of eligible gain from the disposition of qualified small business stock issued by one corporation that may be taken into account in a tax year may not exceed the greater of (a) $10,000,000 ($5,000,000 in the case of married taxpayers filing separately) reduced by the aggregate amount of such gain taken into account in prior years, or (b) 10 times the aggregate bases of qualified stock of the issuer disposed of during the tax year. For purposes of the limitation in (b), the adjusted basis of any qualified stock will not include any additions to basis occurring after the stock was issued.5

      Gain realized by a partner, shareholder, or other participant that is attributable to a disposition of qualified small business stock held by a pass-through entity (i.e., a partnership, S corporation, regulated investment company, or common trust fund) is eligible for the exclusion if the entity held the stock for more than five years, and if the taxpayer held an interest in the pass-through entity at the time of acquisition and at all times since the acquisition of the stock.6

      IRC Section 1202 provides that if the taxpayer has an offsetting short position with respect to any qualified small business stock, the exclusion is unavailable unless (a) the stock was held for more than five years as of the date of entering into the short position, and (b) the taxpayer elects to recognize gain as if the stock were sold at its fair market value on the first day the offsetting position was held.7

      A taxpayer has an “offsetting short position” with respect to any qualified small business stock if he or she (or a related party) has (a) made a short sale of substantially identical property, (b) acquired an option to sell substantially identical property at a fixed price, or (c) to the extent provided in future regulations, entered into any other transaction that substantially reduces the risk of loss from holding the qualified small business stock.8 (See Q 7524 for an explanation of short sales, Q 7528 for an explanation of “substantially identical property” for purposes of the short sale rules, and Q 7556 for a definition of options.)

      Obviously, some offsetting short positions (e.g., a short sale) may also result in constructive sale treatment under the rules of IRC Section 1259 (see Q 7617 to Q 7621). While the IRC does not specify the effect of IRC Section 1259 on IRC Section 1202, it would appear that if the requirements of IRC Section 1202(j) are otherwise met, the exclusion provided under IRC Section 1202 would not be lost merely because immediate gain recognition may be required under IRC Section 1259.

      Any gain excluded under IRC Section 1202 by a married couple filing jointly must be allocated equally between the spouses for purposes of claiming the exclusion in subsequent tax years.9

      Special rules apply to IRC Section 1202 stock for alternative minimum tax purposes. An amount equal to 7 percent of the amount excluded from gross income for the taxable year under IRC Section 1202 will be treated as a preference item.10

      Individual taxpayers may not exclude any gain under IRC Section 1202 in determining net operating loss for the year.11


      1 .IRC Sec. 1202, as amended by ARRA 2009. See also IRC Sec. 1(h)(7).

      2 .IRC Sec. 1202(a)(3), as added by ARRA 2009; Sec. 1241 of ARRA 2009.

      3 .TRA 2010 Sec. 760(a)(1)-(2), ATRA Sec. 324, PATH Sec. 126.

      4 .See IRC Sec. 1202(a)(2).

      5 .IRC Sec. 1202(b).

      6 .IRC Sec. 1202(g).

      7 .IRC Sec. 1202(j)(1).

      8 .IRC Sec. 1202(j)(2).

      9 .IRC Sec. 1202(b)(3)(B).

      10 .IRC Sec. 57(a)(7).

      11 .IRC Sec. 172(d)(2).

  • 7523. Can a taxpayer elect to roll over gain from the sale or exchange of qualified small business stock?

    • Generally, a noncorporate taxpayer, including certain partnerships and S corporations, may elect to roll over gain from the sale or exchange of qualified small business stock held more than six months to the extent that the taxpayer purchases other qualifying small business stock within sixty days of the sale of the original stock.1

      If the rollover election is made, gain will be recognized only to the extent that the amount realized on the sale exceeds (1) the cost of any qualified small business stock purchased by the taxpayer during the sixty-day period beginning on the date of the sale, reduced by (2) any portion of such cost previously taken into account under this rollover provision. The rollover provisions of IRC Section 1045 will not apply to any gain that is treated as ordinary income.2

      Rules similar to those applicable to rollovers of gain by an individual from certain small business stock3 will apply to the rollover of such gain by a partnership or S corporation.4 Thus, for example, the benefit of a tax-free rollover with respect to the sale of small business stock by a partnership will flow through to an “eligible partner”—i.e., a partner who is not a corporation and who held a partnership interest at all times during which the partnership held the small business stock.5 (A similar rule applies to S corporations.)6 For the rules regarding, among other things, (1) the deferral of gain on a partnership’s sale of qualified small business stock followed by an eligible partner’s acquisition of qualified replacement stock, and (2) the deferral of gain on a partner’s sale of qualified small business stock distributed by a partnership, see Treasury Regulation Section 1.1045-1, finalized in 2007.7

      The amount of gain not recognized because of a rollover of qualified small business stock will be applied to reduce (in the order acquired) the basis for determining gain or loss of any qualified small business stock purchased by the taxpayer during the sixty-day rollover period.8

      Ordinarily, the holding period of qualified small business stock purchased in a rollover transaction will include the holding period of the stock sold; but for purposes of determining whether the nonrecognition of gain applies to the stock that is sold, the holding period for the replacement stock begins on the date of purchase. In addition, only the first six months of the taxpayer’s holding period for the replacement stock will be taken into account for purposes of determining whether the active business requirement is met (see Q 7521).9

      An IRC Section 1045 election must be made by the due date (including extensions) for filing the income tax return for the taxable year in which the qualified small business stock is sold.10 The election is made by (1) reporting the entire gain from the sale of qualified small business stock on Schedule D; (2) writing “IRC Section 1045 rollover” directly below the line on which the gain is reported; and (3) entering the amount of the gain deferred under IRC Section 1045 on the same line as (2), above, as a loss, in accordance with the instructions for Schedule D.11 If a taxpayer has more than one sale of qualified small business stock in a taxable year that qualifies for the IRC Section 1045 election, the election can be made for any one or more of those sales. An IRC Section 1045 election is revocable only with the Commissioner’s consent.12

      The Service has stated that in order to be granted approval to make a late Section 1045 election (when the requirements for an automatic extension are not met), the requesting taxpayer must provide evidence to establish that he or she acted reasonably and in good faith and that granting the relief would not prejudice the interests of the government. A taxpayer is deemed to have not acted reasonably and in good faith if the taxpayer either uses hindsight in requesting relief, or was informed in all material respects of the required election and related tax consequences but chose not to file the election. Furthermore, the taxpayer must provide a detailed affidavit from the individuals having knowledge or information about the events leading to the failure to make a valid regulatory election. The affidavit must describe the engagement and responsibilities of the individual as well as the advice that the individual provided to the taxpayer.13


      1 .See IRC Sec. 1045(a).

      2 .IRC Sec. 1045(a).

      3 .IRC Sec. 1202.

      4 .IRC Sec. 1045(b)(5).

      5 .See Treas. Reg. §§1.1045-1(b)(1), 1.1045-1(g)(3)(i).

      6 .General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 167 (the 1998 Blue Book).

      7 .TD 9353, 2007-2 CB 721.

      8 .IRC Sec. 1045(b)(3).

      9 .IRC Secs. 1045(b)(4), 1223(15).

      10 .Rev. Proc. 98-48, 1998-2 CB 367.

      11 .Rev. Proc. 98-48, 1998-2 CB 367.

      12 .Rev. Proc. 98-48, 1998-2 CB 367.

      13 .Let. Rul. 200604004.

  • 7524. What is a “short sale”? What is meant by the expression “short against the box”?

    • In a “short sale” an individual contracts to sell stock (or other securities) that the individual “does not own or the certificates for which are not within his [or her] control so as to be available for delivery when, under the rules of the Exchange, delivery must be made.”1 Thus, in a short sale, the seller usually borrows the stock (or security) for delivery to the buyer. (The seller must generally pay a premium for the privilege of borrowing such stock and will usually be required to reimburse the lender for any dividends paid during the loan period.) At a later date, the short seller will repay the borrowed stock to the lender with shares the seller held (but that were not available) at the time of the short sale or with shares purchased in the market, whichever he or she chooses.2

      The act of delivering stock (or securities) to the lender in repayment for the borrowed shares is referred to as “closing” the short sale. The date the sales agreement is made is considered to be the “date of the short sale.”

      In a sale “short against the box” the short seller already owns (on the date of the short sale) shares of stock (or securities) that are identical to those sold short, but chooses to borrow the necessary shares rather than deliver the shares owned.

      A contract to sell stock or securities on a “when issued” basis is considered a short sale; the performance of the contract is considered to be the “closing” of that short sale.3

      A transaction in which a taxpayer purchases convertible bonds and as nearly simultaneously as possible sells the stock into which the bonds are convertible at a price relatively higher than the price of the bonds, then converts the bonds and uses the stock received to close the stock sale, is a short sale.4 (Such a transaction is also an arbitrage operation, see Q 7533.) See Q 7525 regarding the tax treatment of short sales.

      The purchase of a put option (see Q 7561, Q 7564) is treated as a short sale for some purposes.5 It is unclear whether such treatment will be applied for purposes of the constructive sales rules of IRC Section 1259. See Q 7617 to Q 7621.

      In applying the short sale rules, a securities futures contract (see Q 7586) to acquire property will be treated in a manner similar to the property itself.6 Thus, for example, the holding of a securities futures contract to acquire property and the short sale of property that is substantially identical to the property under the contract will result in the application of the rules under IRC Section 1233(b) (regarding short-term gains and holding periods). (Because securities futures contracts are not treated as commodity futures contracts under IRC Section 1234B(d), the rule providing that commodity futures are not substantially identical if they call for delivery in different months does not apply.) In addition, a securities futures contract to sell is treated as a short sale of the property.7

      The SEC has made permanent a rule that seeks to reduce the potential for abusive “naked” short selling in the securities market. Rule 204 requires broker-dealers to promptly purchase or borrow securities to deliver on a short sale. The rule became effective July 31, 2009.8


      1 .Provost v. U.S., 269 U.S. 443, 450 (1926).

      2 .See also Rev. Rul. 72-478, 1972-2 CB 487.

      3 .See S. Rep. No. 2375 (Rev. Act of 1950), 1950-2 CB 545; Treas. Reg. §1.1233-1(c)(6), Ex. (6).

      4 .Rev. Rul. 53- 154, 1953-2 CB 173.

      5 .See, e.g., IRC Sec. 1233(b).

      6 .H.R. Conf. Rep. No. 106-1033 (CRTRA 2000). See IRC Sec. 1233(e)(2)(D).

      7 .IRC Sec. 1233(e)(2)(E); H.R. Conf. Rep. No. 106-1033 (CRTRA 2000). See IRC Sec. 1234B(b).

      8 .Rule 204 of Regulation SHO (17 CFR 242.204); Release No. 34-60388, 74 Fed. Reg. 38266 (7-31-2009), SEC Press Release 2009-172 (7-27-2009).

  • 7525. When and how is a short sale taxed?

    • The timing of the taxable event depends on when the short sale occurs and whether it constitutes a constructive sale of an appreciated financial position(see Q 7617 to Q 7621). Special rules also govern the determination of the holding period of property subject to a short sale (and thus its tax treatment) as explained below.

      Generally, if a taxpayer holds an appreciated financial position (see Q 7617) that is the same as or substantially identical to the property sold short, the short sale will be treated as a constructive sale of that position, unless certain requirements are met for closing out the short position.1 Furthermore, if a taxpayer holds a short sale position that has appreciated, the acquisition of the same or substantially identical property (e.g., to cover the short sale) constitutes a constructive sale of the short sale position, which is subject to the same rules.2

      Unless certain exceptions apply, a constructive sale results in immediate recognition of gain as if the position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale.3 For an explanation of the constructive sale rules for appreciated financial positions under IRC Section 1259, see Q 7617 to Q 7621.

      A sale of appreciated stock “short against the box” constitutes a constructive sale of an appreciated financial position (see Q 7617 to Q 7621).4 (Under earlier law, short sales against the box were taxed as a short sale.)5

      The nature of capital gain recognized as a result of a constructive sale of an appreciated financial position may be subject to the rules of IRC Section 1233 and regulations thereunder, which generally govern the determination of a taxpayer’s holding period for gain or loss on short sale transactions. (Those rules are described in Q 7526.) The treatment of capital gains and losses is explained in Q704.

      In the case of a short sale that, if terminated, would result in a loss, the taxable event following a short sale does not occur until the seller delivers stock to the lender to “close” the sale, not when the sales agreement was made, nor when the borrowed stock was delivered to the purchaser (see Q 7524).6 If the seller’s tax basis exceeds the sale proceeds, the seller will realize a capital loss.7

      If the seller does not hold the same or substantially identical property, a short sale alone will not result in constructive sale treatment; but at such time as the seller acquires the same or substantially identical property to close the sale, a constructive sale takes place, under the rules described above, if the short position has appreciated.8

      For the tax treatment of the “premium” paid by the short seller to borrow the stock for delivery to the buyer, see Q 7529. The treatment of capital gain or loss on sales is subject to the rules set forth in Q 702.

      Special rules are provided where a taxpayer holds an offsetting short position with respect to qualified small business stock, see Q 7522.

      If a short sale is deemed to be part of a conversion transaction, a portion of the gain recognized upon the sale of stock sold short may be treated as ordinary income.9 See Q 7615 to Q 7616 for an explanation of conversion transactions and the tax treatment of them.

      No deduction is allowed for a loss incurred in a short sale if, within the sixty-one-day period that begins thirty days before the date the short sale was closed and ends thirty days after such date, the short seller entered into a wash sale.10


      1 .See IRC Secs. 1259(c)(1)(A), 1259(c)(3).

      2 .IRC Sec. 1259(c)(1)(D).

      3 .See IRC Sec. 1259(a).

      4 .IRC Secs. 1259(b)(1), 1259(c)(1)(A).

      5 .DuPont v. Comm., 110 F.2d 641 (3d Cir.), cert. den., 311 U.S. 657 (1940).

      6 .See Rev. Rul. 2002-44, 2002-2 CB 84.

      7 .Treas. Reg. §1.1233-1(a).

      8 .See IRC Sec. 1259(c)(1)(D).

      9 .IRC Sec. 1258(a).

      10 .See IRC Sec. 1091(e); AOD 1985-019.

  • 7526. In the context of a short sale, what are the rules for determining whether a capital gain (or loss) is taxed as a long-term or short-term gain (or loss)?

    • Ordinarily, whether capital gain or loss on a short sale is long-term or short-term will be determined by how long the seller held the stock used to close the sale.1 For most purposes, the holding period requirement for claiming long-term capital gain tax treatment is “more than one year.” (See Q 702 for the treatment of capital gains and losses.)

      Under provisions predating the constructive sale rules (see Q 7617 to Q 7621) to prevent individuals from using short sales to convert short-term gains to long-term gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, the IRC and regulations provide special rules as follows:

      (1) If on the date the short sale is closed (see below), any “substantially identical property” (see Q 7528) has been held by the seller for a period of one year or less, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.2 This is true even though the stock actually used to close the short sale has been held by the seller for more than one year. This rule does not apply to losses realized on the property used to close the sale.

      (2) If any substantially identical property is acquired by the seller after the short sale and on or before the date the sale is closed, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.3 This is true regardless of how long the substantially identical property has been held, how long the stock used to close the short sale has been held, and how much time has elapsed between the short sale and the date the sale is closed. This rule does not apply to losses realized on the property used to close the sale.

      (3) The holding period of any substantially identical property held one year or less, or acquired after the short sale and on or before the date the short sale is closed will, to the extent of the quantity of stock sold short, be deemed to have begun on the date the sale is closed or the date such property is sold or otherwise disposed of, whichever is earlier. If the quantity of such substantially identical property held for one year or less or so acquired exceeds the quantity of stock sold short, the “renewed” holding period will normally be applied to individual units of such property in the order in which they were acquired (beginning with earliest acquisition), but only to so much of the property as does not exceed the quantity sold short. Any excess retains its original holding period.4 However, where the short sale is entered into as part of an arbitrage operation in stocks or securities (see Q 7533), this order of application is altered so that the “renewed” holding period will be applied first to substantially identical property acquired for arbitrage operations and held at the close of business on the day of the short sale and then in the order of acquisition as described in the previous sentence. The holding period of substantially identical property not acquired for arbitrage operations will be affected only to the extent that the quantity sold short exceeds the amount of substantially identical property acquired for arbitrage operations.5

      If substantially identical property acquired for arbitrage operations is disposed of without closing the short sale, see Q 7534.

      (4) If on the date of a short sale any substantially identical property has been held by the seller for more than one year, any loss realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be long-term capital loss.6 This is true even though the stock actually used to close the short sale has been held by the seller for a year or less. This rule does not apply to gains realized on the property used to close the sale.

      Capital gain or loss from the sale or exchange of a securities futures contract—see Q 7586—to sell property (i.e., the short side of a futures contract) will generally be short-term capital gain or loss unless the position is part of a straddle, see Q 7599. In other words, a securities futures contract to sell property is treated as equivalent to a short sale of the underlying property.7

      See Q 7528 and Q 7539 for a discussion of what constitutes substantially identical property for purposes of these rules.


      1 .Treas. Reg. §1.1233-1(a)(3). See Bingham, 27 BTA 186 (1932), acq. 1933-1 CB 2.

      2 .IRC Sec. 1233(b)(1); Treas. Reg. §1.1233-1(c).

      3 .IRC Sec. 1233(b)(1); Treas. Reg. §1.1233-1(c).

      4 .IRC Sec. 1233(b)(2); Treas. Reg. §1.1233-1(c)(2).

      5 .IRC Sec. 1233(f); Treas. Reg. §1.1233-1(f).

      6 .IRC Sec. 1233(d); Treas. Reg. §1.1233-1(c)(4).

      7 .H.R. Conf. Rep. No. 106-1033 (CRTRA 2000). See IRC Sec. 1234B(b).

  • 7527. How is a short sale taxed when the property sold becomes substantially worthless?

    • If a taxpayer enters into a short sale of property and the property becomes substantially worthless, a special rule requires that the taxpayer recognize gain in the same manner as if the short sale were closed when the property became substantially worthless.1 (To the extent expected to be provided in future regulations, this rule will also apply with respect to options and offsetting notional principal contracts with respect to property, any future or forward contract to deliver property, and any similar transaction.)

      Special rules are provided regarding the statute of limitations for assessing a deficiency if property becomes substantially worthless during a taxable year and any short sale of property remains open at the time the property becomes substantially worthless.2 For an explanation of the taxation of stock or other securities that become worthless, see Q 7540.

      The definition of “substantially identical stock or securities” for purposes of the short sale rules is the same as that used for purposes of the wash sale rule, see Q 7528, Q 7539. It would appear that the same definition would be used for purposes of constructive sales of appreciated financial positions, see Q 7617 to Q 7621.


      1 .IRC Sec. 1233(h)(1).

      2 .IRC Sec. 1233(h)(2).

  • 7528. What is “substantially identical property”?

    • In the case of stock and securities, “substantially identical property,” for purposes of the short sale rules, has the meaning given to “substantially identical stock or securities” for purposes of the wash sale rule.1 See Q 7539 for details. It would appear that the same definition should apply for purposes of constructive sales of appreciated financial positions under IRC Section 1259.

      A securities futures contract (see Q 7586) to acquire substantially identical property will be treated as substantially identical property.2

      In addition, for purposes of short sales entered into as part of an arbitrage operation (see Q 7533), a taxpayer will be deemed to hold substantially identical property for arbitrage operations at the close of any business day if he or she owns any other property acquired for arbitrage operations (whether or not substantially identical) or has entered any contract in an arbitrage operation which in either case, at the close of that day, gives the taxpayer the right to receive or acquire substantially identical property.3


      1 .Treas. Reg. §1.1233-1(d).

      2 .IRC Sec. 1233(e)(2)(D).

      3 .IRC Sec. 1233(f)(3); Treas. Reg. §1.1233-1(f)(2).

  • 7529. May an investor deduct the premium paid to borrow stock in connection with a short sale?

    • The premium paid by an investor to borrow the stock delivered to the buyer in a short sale is an expense incurred for the production of income.1 But the amount is generally treated as interest expense (subject to the limitation on the deduction of investment interest).2 As a result, a short seller may find that only a portion (or none) of the premium is deductible for income tax purposes.3 See Q 8037 regarding the deduction of investment interest.

      Furthermore, if the proceeds of a short sale are used to purchase or carry tax-exempt obligations, the amount of the premium is treated as interest for purposes of the general rule that prohibits the deduction of interest expense incurred or continued to purchase or carry tax-exempt obligations. (But this does not apply if the short seller provided cash as collateral for the short sale and does not receive material earnings on such cash.)4 See Q 8041 and Q 8047 for an explanation of this rule.

      If the proceeds of a short sale are used to purchase or carry short-term obligations or market discount bonds, an otherwise allowable deduction of the short sale premium may have to be deferred under the rules discussed in Q 8042 and Q 8043. (A short-term obligation is one which has a fixed maturity date not more than one year from the date of issue.)5


      1 .Rev. Rul. 72-521, 1972-2 CB 128.

      2 .It is not, however, a miscellaneous itemized deduction subject to the limitations of IRC Section 67. IRC Sec. 67(b)(8).

      3 .IRC Sec. 163(d).

      4 .IRC Secs. 265(a)(2), 265(a)(5).

      5 .IRC Secs. 1277, 1282, 1283.

  • 7530. May an investor deduct expenses incurred in reimbursing the lender of stock in a short sale for cash dividends paid on the borrowed stock?

    • The answer generally depends on the period the short sale is open. If a short sale is held open less than forty-six days, any amount paid by the short seller to reimburse the lender of stock for cash dividends paid on the borrowed stock during the period of the loan will not be deductible by the seller. Instead, the seller will be required to add such amount to the tax basis in the stock used to close the short sale (i.e., the short seller will be required to capitalize the expenditure).1

      However, if the amount of the cash dividends being reimbursed equals or exceeds 10 percent (5 percent in the case of a short sale of stock that is preferred as to dividends) of the amount realized by the short seller in the short sale, the expenditure must be capitalized (i.e., added to the basis of the stock used to close the short sale) unless the short sale is open for at least 366 days.2 For this purpose, all dividends paid on the short sale stock that have ex-dividend dates within the same eighty-five consecutive day period must be treated as a single dividend.3 (Dividends that equal or exceed the 10 percent (or 5 percent) threshold are referred to as “extraordinary dividends.”)4

      Assuming the short sale is open for a period of forty-six days (366 days in the case of an extraordinary dividend) or more, the amount paid by the short seller to reimburse the lender for cash dividends is usually deductible as an expense incurred in the production of income.5 However, when it appears that the sole motive for the short sale was the reduction of income taxes (through the deduction or offset of capital losses), the Service has taken the position that such amounts are not deductible.6

      If the short seller must report ordinary income as a result of receiving compensation for the use of collateral provided in connection with borrowing stock for the short sale, he or she will generally be permitted to deduct, to the extent of such income, the amounts paid to reimburse the lender for dividends even though the sale was not open more than forty-five days. (This exception does not apply in the case of “extraordinary dividends.”)7

      For purposes of determining whether a short sale has been open for at least forty-six (or 366) days, the running of such period must be suspended during any period in which (1) the seller holds, has an option to buy, or is under a contractual obligation to buy, stock or securities that are substantially identical to those sold short, or (2) as set forth in regulations, the seller has diminished his or her risk of loss by holding one or more other positions in substantially similar or related property.8 For a discussion of the deductibility of stock dividends and liquidating dividends, see Q 7532.


      1 1.IRC Sec. 263(h)(1).

      2 .IRC Secs. 263(h)(2), (3); 1059(c)(1), (2).

      3 .IRC Sec. 1059(c)(3).

      4 .IRC Sec. 263(h)(2), (3).

      5 .See Rev. Rul. 72-521, 1972-2 CB 128.

      6 .See Hart v. Comm., 338 F.2d 410 (2d Cir. 1964), agreeing with the Service.

      7 .IRC Sec. 263(h)(5).

      8 .IRC Sec. 263(h)(4).

  • 7531. Are there circumstances in which the deduction allowable for expenses incurred in reimbursing the lender of stock in a short sale for cash dividends paid on the borrowed stock may be limited or deferred?

    • Even though an amount is deductible under the foregoing rules, a short seller may still find that the deduction is limited or must be deferred as follows:

      (1)If the proceeds of the short sale are used to purchase or carry tax-exempt obligations, the deduction may be disallowed under the general rule prohibiting the deduction of interest expense incurred or continued to purchase or carry tax-exempts. (This does not apply if the seller provided cash as collateral for the short sale and does not receive material earnings on such cash.) (See Q 8041, Q 8047.)1

      (2)If the proceeds of the short sale are used to purchase or carry market discount bonds or short-term obligations, an otherwise allowable deduction of amounts incurred to reimburse the lender of stock for cash dividends may have to be deferred under the rules discussed in Q 8042 and Q 8043. (A short-term obligation is a bond, note, debenture, certificate, or other evidence of indebtedness that has a fixed maturity date not more than one year from the date of issue.)2

      (3)In any event, the amount of the otherwise deductible reimbursement must be treated as an investment interest expense and thus is subject (along with any other investment interest expense) to the general limitation on the deduction of investment interest (see Q 8037).3

      The amount received by the lender of stock as a reimbursement for a cash dividend from the borrower is not a dividend,4 and it is therefore not eligible for the preferential treatment applicable to qualified dividends. It is simply ordinary income.


      1 .IRC Sec. 265(a)(5).

      2 .IRC Secs. 1277, 1282, 1283.

      3 .IRC Sec. 163(d)(3)(C).

      4 .See Rev. Rul. 60-177, 1960-1 CB 9.

  • 7532. May an investor deduct expenses incurred in reimbursing the lender of stock in a short sale for stock dividends and liquidating dividends paid on the borrowed stock?

    • The cost of purchasing additional shares of stock to reimburse the lender for nontaxable stock dividends and any amount paid to reimburse the lender for a liquidating dividend are always capital expenditures and not tax deductible.1 As such, these amounts should be added to the investor’s basis in the stock used to close the short sale.


      1 .Rev. Rul. 72-521, 1972-2 CB 128.

  • 7533. For purposes of the short sale rules, what are “arbitrage operations”?

    • “Arbitrage operations” are transactions involving the purchase and sale of stock or securities (or the right to acquire stock or securities) entered into for the purpose of profiting from a current difference between the price of the property purchased and the price of the property sold. The property purchased must either be identical to the property sold (e.g., stock X trading for different prices on different exchanges) or must entitle the owner to acquire property that is identical to the property sold (e.g., bonds convertible into stock X). To qualify as an arbitrage operation for purposes of the short sale rules, the taxpayer must properly identify the transaction as an arbitrage operation on the taxpayer’s records as soon as the taxpayer is able to do so; ordinarily, this must be done on the day of the transaction. Only property properly identified as such will be treated as property acquired for arbitrage operations.1

      Property that has been properly identified as acquired for arbitrage operations will continue to be treated as such even though, because of subsequent events, the taxpayer sells the property outright rather than using it to complete the arbitrage operation.2 See Q 7534 as to the effects of disposing of such property without closing a short sale that was entered into as part of the arbitrage operation.

      It is unclear whether an arbitrage operation may be subject to treatment as a conversion transaction (see Q 7615, Q 7616) or whether it may constitute a constructive sale of an appreciated financial position (see Q 7617 to Q 7621).


      1 .IRC Sec. 1233(f); Treas. Reg. §1.1233-1(f)(3).

      2 .Treas. Reg. §1.1233-1(f)(3).

  • 7534. What are the effects on the short sale rules if substantially identical property acquired for arbitrage operations is disposed of without closing a short sale that was part of arbitrage operations?

    • If substantially identical property acquired for arbitrage operations is sold or otherwise disposed of without closing the short sale that was entered into as part of the arbitrage operations so that a net short position in assets acquired for arbitrage is created, a short sale in the amount of the net short position will be deemed to have been made on the date that short position is created. The holding period of any substantially identical property not acquired for arbitrage operations will then be determined under the rules discussed in Q 7525 as though the “deemed” short sale was not entered into as part of an arbitrage operation.1

      Example: On August 13, Mr. Copeland buys 100 bonds of X corporation for purposes other than arbitrage operations. The bonds are convertible (one bond for one share) at Mr. Copeland’s option into common stock of X corporation. On November 1, Mr. Copeland sells short 100 shares of X common stock, buys an additional 100 bonds of X corporation, and identifies both transactions as part of arbitrage operations. The bonds acquired on August 13 and November 1 are, on the basis of all the facts, substantially identical to the X common stock. On December 1, Mr. Copeland sells the bonds acquired on November 1, but does not close the short sale. Since a net short position in assets acquired for arbitrage operations is thus created, a short sale is deemed to have been made on December 1. Accordingly, the holding period of the bonds acquired on August 13 will, by application of the rule discussed in Q 7525, begin on the date that the “deemed” short sale is closed (or, if earlier, the date such bonds are disposed of or sold).2

      It is unclear whether certain arbitrage operations may be subject to treatment as a constructive sale of an appreciated financial position (see Q 7617 to Q 7621).


      1 .Treas. Reg. §1.1233-1(f)(1)(ii).

      2 .See Treas. Reg. §1.1233-1(f)(1)(iii).

  • 7535. How is a short sale taxed if the seller dies shortly after making the short sale and the estate or a trust “closes” the sale?

    • If the short sale constitutes a constructive sale of an appreciated financial position, it will be subject to special rules explained in Q 7621. Otherwise, a short sale closed by a seller’s estate will be taxed under the earlier rules for short sales (see Q 7525). But for purposes of determining gain or loss, if the sale is closed with stock owned by the seller at death, the tax basis in that stock will be its value for federal estate tax purposes – generally, fair market value on the date of the seller’s death.1

      It was determined (under a ruling pre-dating the constructive sales rules of IRC Section 1259) that where a trust established by a seller closed a short sale after the death of the seller with stock it held for the seller’s benefit, the basis of such stock generally would be its fair market value either on the date of the seller’s death or on an alternative valuation date determined under IRC Section 2032.2

      For short sales that are not subject to the constructive sales rules of IRC Section 1259 (see Q 7525), the taxable event of the short sale occurred when the estate or trust “closed” the sale.3 Thus, any gain recognized on the short sale would not constitute “income in respect of a decedent” (see Q 745). Special rules may apply to decedents who held an open short sale position within three years of death (see Q 7621).


      1 .Rev. Rul. 73-524, 1973-2 CB 307.

      2 .Let. Rul. 9319005.

      3 .See Rev. Rul. 73-524 and Let. Rul. 9319005.

  • 7536. What is a “wash sale”?

    • A “wash sale” is a sale or other disposition of stock or securities in which the seller, within a sixty-one-day period (beginning thirty days before and ending thirty days after the date of such sale or disposition), replaces the stock or securities by acquiring (by way of a purchase or an exchange on which the full gain or loss is recognized for tax purposes), or entering a contract or option to acquire, substantially identical stock or securities.1 Typically, the objective of a wash sale – were it not subject to the special rules of IRC Section 1091(a) explained in Q 7537 – would be for the taxpayer to take advantage of the deduction for capital losses, while maintaining the taxpayer’s position in the corporation by purchasing substantially identical stock or securities. From a tax standpoint, it is as if nothing has happened, and IRC Section 1091(a) treats the sale as a non-event.

      The replacement of stock or securities by way of gift, inheritance, or tax-free exchange will not result in a wash sale.2 For the definition of “substantially identical stock or securities,” see Q 7539. Except as provided in regulations, the term “stock or securities” includes “contracts or options to acquire or sell stock or securities.” For an explanation, see Q 7559.

      If a taxpayer sells stock or securities for a loss, acquiring substantially identical stock or securities within a traditional IRA or Roth IRA within the sixty-one-day period may constitute a wash sale.3

      Where there is no substantial likelihood that a put option (see Q 7561) will not be exercised, its sale will be treated as a contract to acquire the stock.4

      For purposes of the wash sale rules, a stock warrant is considered to be an option to acquire stock of the issuing corporation.5 Preferred stock that is convertible into common stock of the same corporation without restriction is considered to be an option to acquire such common stock.6

      A seller of stock who agrees at the time of the sale to repurchase that same stock after a minimum of thirty days has entered into a contract, and the sale is a wash sale. It is irrelevant whether the contract is enforceable under state law.7

      A bona fide sale of a portion of the shares of stock purchased in a single lot for purposes of reducing the purchaser’s holdings in that stock is not a wash sale even though the sale occurs within thirty days after the lot was acquired.8

      A disposition of stock or securities may not be taken out of the definition of a “wash sale” by merely postponing delivery until more than thirty days after the date the shares of stock or securities are replaced.9 A purchase of substantially identical stock or securities during the sixty-one-day period will trigger the wash sale rules even though the purchase is made on margin or pursuant to subscription rights acquired prior to the beginning of the sixty-one-day period.10

      Where a taxpayer received ten shares of stock as a bonus from his employer, sold them at a loss, and then within the sixty-one-day period received another bonus of ten shares of the same stock, the Service ruled that a wash sale had occurred; the tax basis of shares received as a bonus is their fair market value at the time of payment.11 It appears that the sale or purchase of “when-issued” securities is deemed to occur on the date the final settlement is made.12

      An employee who, under an employer-employee restricted stock option plan, was granted an option to purchase stock of his or her employer was deemed for purposes of the wash sale rules to have entered into an option to acquire that stock on the date the option was granted; the stock purchased pursuant to such option was deemed to have been acquired on the date the certificates were issued.13 See Q 7546 to Q 7555 for the tax treatment of incentive stock options.

      Securities futures contracts. “The wash sale rules apply to any loss from the sale, exchange, or termination of a securities futures contract (other than a dealer securities futures contract) if within a period beginning thirty days before the date of such sale, exchange, or termination and ending thirty days after such date: (1) stock that is substantially identical to the stock to which the contract relates is sold; (2) a short sale of substantially identical stock is entered into; or (3) another securities futures contract to sell substantially identical stock is entered into.”14

      The taxation of a wash sale is explained in Q 7537. For the application of the wash sale rules in the context of a short sale, see Q 7525.


      1 .IRC Sec. 1091(a); Treas. Reg. §1.1091-1(a).

      2 .See Treas. Reg. §1.1091-1(f).

      3 .Rev. Rul. 2008-5, 2008-1 CB 271.

      4 .Rev. Rul. 85-87, 1985-1 CB 268.

      5 .Rev. Rul. 56-406, 1956-2 CB 523.

      6 .Rev. Rul. 77-201, 1977-1 CB 250.

      7 .Est. of Estroff v. Comm., TC Memo 1983-666.

      8 .Rev. Rul. 56-602, 1956-2 CB 527.

      9 .Rev. Rul. 59-418, 1959-2 CB 184.

      10 .See respectively, Rev. Rul. 71-316, 1971-2 CB 311; Rev. Rul. 71-520, 1971-2 CB 311.

      11 .Rev. Rul. 73-329, 1973-2 CB 202.

      12 .See I.T. 3858, 1947-2 CB 71.

      13 .Rev. Rul. 56-452, 1956-2 CB 525.

      14 .See IRC Sec. 1091(e); Joint Committee on Taxation, Technical Explanation of the Job Creation and Worker Assistance Act of 2002 (JCX-12-02).

  • 7537. How is the sale or disposition of stock or securities in a wash sale taxed?

    • No special tax rules apply if an investor realizes a gain in a wash sale of stock or other securities; rather, the sale will be taxed under the rules peculiar to both the type of disposition and to the particular stock or security sold. For the taxation of gain on treasury bills, bonds and notes, and municipal bonds, see respectively Q 7626, Q 7632, and Q 7663. For taxation of gain on corporate obligations, see Q 7628 and Q 7635. For taxation of stock, see Q 7517 to Q 7522.

      On the other hand, to the extent that shares of stock or securities sold are replaced in a wash sale (as defined in Q 7536), any loss realized on the stock or securities sold may not be recognized for income tax purposes and, therefore, may not be used to offset capital gains or otherwise deducted. However, if the quantity of the stock or securities sold at a loss exceeds the quantity replaced, the loss realized on the excess shares or securities may be recognized as a capital loss for income tax purposes.1


      1 .IRC Sec. 1091(b); Treas. Reg. §1.1091-1(c); Rev. Rul. 70-231, 1970-1 CB 171.

  • 7538. What effect does a wash sale have on the replacement stock or securities obtained in the sale?

    • As part of a scheme to postpone the recognition of an economic wash sale loss, rather than disallow it permanently, the IRC provides that both the tax basis and holding period of the replacement stock or securities are to be adjusted. Specifically, the tax basis of the replacement stock or securities is deemed to be equal to the tax basis of the stock or securities disposed of in the wash sale, increased or decreased, as the case may be, by the difference (if any) between the price at which the property was acquired and the price at which the substantially identical stock or securities were sold or otherwise disposed of. This generally has the effect of adding the amount of the unrecognized loss to the cost basis of the replacement stock or securities.1 The loss is therefore deferred, not eliminated forever. It can be recognized when the stock or securities are sold or exchanged in a transaction that is not a wash sale.

      Where a taxpayer sold stock or securities for a loss and acquired substantially identical stock or securities within a traditional IRA or Roth IRA within the sixty-one-day period, the IRS found a wash sale had occurred. In this case, the taxpayer’s basis in the traditional IRA or Roth IRA was not increased by virtue of IRC Section 1091(d). 2

      Furthermore, the investor’s holding period in the stock or securities disposed of in the wash sale is “tacked” (i.e., added) onto the holding period in the replacement stock or securities.3

      Where identical quantities of stock or securities are sold and replaced in a wash sale, there is little problem in applying the rules discussed above. But where unequal quantities are sold and replaced or where sales and/or replacements are made in multiple lots (or transactions), the stock or securities sold and the replacement stock or securities must be matched on a chronological basis (beginning with the earliest loss and earliest replacement) before the rules can be properly applied.4

      Example: On March 1, Ms. Whalen sells 1000 shares of X stock (lot A) at a loss of $10,000 and a second lot of 1000 (lot B) on March 2 at a loss of $25,000. On March 10, Ms. Whalen purchases 1000 shares of X stock (lot C). This purchase will result in the nonrecognition for income tax purposes of the $10,000 loss on lot A and an increase of $10,000 in the tax basis of the replacement stock (lot C). In addition, the holding period of lot C will include the holding period of lot A (i.e., the holding period of lot A will be “tacked” onto the holding period of lot C).

      If, on March 20, Ms. Whalen purchases another lot (lot D) of 1000 shares of stock X, the $25,000 loss on the sale of lot B will not be recognized for income tax purposes. The tax basis of lot D will be increased by $25,000, and the holding period of lot B will be tacked onto the holding period of lot D.


      1 .IRC Sec. 1091(d); Treas. Reg. §1.1091-2.

      2 .Rev. Rul. 2008-5, 2008-1 CB 271.

      3 .IRC Sec. 1223(4).

      4 .IRC Secs. 1091(b), 1091(c); Treas. Reg. §1.1091-1.

  • 7539. When are stock and securities “substantially identical” for purposes of the wash sale rules?

    • Whether stock or securities are substantially identical depends on the facts and circumstances of each case.1 Beyond that, unfortunately, the IRC and the regulations offer little guidance as to when stock or securities are substantially identical, but it is clear that “something less than precise correspondence will suffice.”2

      Ordinarily, shares or securities of one corporation are not substantially identical to shares or securities of another corporation. However, a different result may occur as, for example, in reorganization, where facts and circumstances indicate that the stock and securities of predecessor and successor corporations are substantially identical.3 Where voting trust certificates eventually could be exchanged for common stock held by the trust, the certificates were held to be substantially identical to the common stock of the same corporation.4

      When preferred stock is convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make the preferred and common stock substantially identical.5 Also, when a sale of a stock warrant is followed within thirty days by a purchase of stock of the same corporation, the warrant and the newly acquired stock are substantially identical only if the relative values and price changes are similar.6

      For purposes of the wash sale rules, options to buy stock or securities apparently can be considered substantially identical not only to the underlying stock, but also to other options or contracts to buy stock or securities.7

      Under the wash sale rules, a contract or option to acquire or sell stock or securities will include options and contracts that are (or may be) settled in cash or property other than the stock or securities to which the contract relates.8 Thus, for example, the acquisition within the period set forth in IRC Section 1091 of a securities futures contract (see Q 7586) to acquire stock of a corporation could cause the taxpayer’s loss on the sale of stock in that corporation to be disallowed under the wash sale rules, notwithstanding that the contract may be settled in cash.9

      Generally, bonds are substantially identical if they are not substantially different in any material feature and are not substantially different in several material features considered together (each of which, if considered alone, would not be regarded as substantial).10 Although very few concrete criteria exist to aid in determining which features are material and when such material features alone or in conjunction will result in a substantial difference, the following may be of guidance:

      1. The interest rate of a bond is considered a material feature.11

      2. In determining whether bonds purchased are substantially identical to bonds sold, the bonds purchased must be compared as they existed when purchased with the bonds sold as they existed when sold.12

      3. Issue dates of bonds are not material features unless some material features are dependent on such dates.13

      4. Whether a difference in maturity dates is substantial or not is directly affected by the total time period to maturity (i.e., six months added to the duration of one year is vital; added to a duration of twenty years is negligible).14


      1 .Treas. Reg. §1.1233-1(d)(1).

      2 .Hanlin v. Comm., 108 F.2d 429 (3d Cir. 1939).

      3 .Treas. Reg. §1.1233-1(d)(1).

      4 .See Kidder v. Comm., 30 BTA 59 (1934).

      5 .Treas. Reg. §1.1233-1(d)(1); Rev. Rul. 77-201, 1977-1 CB 250.

      6 .GCM 39036 (9-22-83).

      7 .See IRC Sec. 1091(a).

      8 .H.R. Conf. Rep. No. 106-1033 (CRTRA 2000).

      9 .H.R. Conf. Rep. No. 106-1033 (CRTRA 2000). See IRC Sec. 1091(f).

      10 .Rev. Rul. 58-211, 1958-1 CB 529.

      11 .Rev. Rul. 60-195, 1960-1 CB 300.

      12 .Rev. Rul. 58-211, 1958-1 CB 529.

      13 .Rev. Rul. 58-210, 1958-1 CB 523.

      14 .Hanlin v. Comm., 108 F.2d 429 (3rd Cir. 1939).