Capital Gains & Losses

Words you may need to know (see Glossary):

• Call
• Commodity future
• Conversion transaction
• Forward contract
• Limited partner
• Listed option
• Nonequity option
• Options dealer
• Put
• Regulated futures contract
• Section 1256 contract
• Straddle
• Wash sale

This section discusses the tax treatment of gains and losses from different types of investment transactions.

Character of gain or loss. You need to classify your gains and losses as either ordinary or capital gains or losses. You then need to classify your capital gains and losses as either short term or long term. If you have long-term gains and losses, you must identify your 28% rate gains and losses. If you have a net capital gain, you must also identify your qualified 5-year gain and any unrecaptured section 1250 gain.

The correct classification and identification helps you figure the limit on capital losses and the correct tax on capital gains. For information about determining whether your capital gain or loss is short term or long term, see Holding Period, later. For information about 28% rate gain or loss, qualified 5-year gain, and unrecaptured section 1250 gain, see Reporting Capital Gains and Losses and Capital Gains Tax Rates, later.

Capital or Ordinary Gain or Loss

If you have a taxable gain or a deductible loss from a transaction, it may be either a capital gain or loss or an ordinary gain or loss, depending on the circumstances. Generally, a sale or trade of a capital asset (defined next) results in a capital gain or loss. A sale or trade of a noncapital asset generally results in ordinary gain or loss. Depending on the circumstances, a gain or loss on a sale or trade of property used in a trade or business may be treated as either capital or ordinary, as explained in Publication 544. In some situations, part of your gain or loss may be a capital gain or loss, and part may be an ordinary gain or loss.

Capital Assets and Noncapital Assets

For the most part, everything you own and use for personal purposes, pleasure, or investment is a capital asset. Some examples are:

• Stocks or bonds held in your personal account,
• A house owned and used by you and your family,
• Household furnishings,
• A car used for pleasure or commuting,
• Coin or stamp collections,
• Gems and jewelry, and
• Gold, silver, or any other metal.

Any property you own is a capital asset, except the following noncapital assets.

1. Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers.
2. Depreciable property used in your trade or business, even if fully depreciated.
3. Real property used in your trade or business.
4. A copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property --
1. Created by your personal efforts,
2. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
3. Acquired under circumstances (for example, by gift) entitling you to the basis of the person who created the property or for whom it was prepared or produced.
5. Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of property described in (1).
6. U.S. Government publications that you received from the government free or for less than the normal sales price, or that you acquired under circumstances entitling you to the basis of someone who received the publications free or for less than the normal sales price.
7. Certain commodities derivative financial instruments held by commodities derivatives dealers. For more information, see section 1221 of the Internal Revenue Code.
8. Hedging transactions, but only if the transaction is clearly identified as a hedging transaction before the close of the day on which it was acquired, originated, or entered into. For more information, see the definition of "hedging transaction" earlier, and the discussion of hedging transactions under Commodity Futures, later.
9. Supplies of a type you regularly use or consume in the ordinary course of your trade or business.

Investment property. Investment property is a capital asset. Any gain or loss from its sale or trade generally is a capital gain or loss.

Gold, silver, stamps, coins, gems, etc. These are capital assets except when they are held for sale by a dealer. Any gain or loss from their sale or trade generally is a capital gain or loss.

Stocks, stock rights, and bonds. All of these, including stock received as a dividend, are capital assets except when they are held for sale by a securities dealer. However, see Losses on Section 1244 (Small Business) Stock and Losses on Small Business Investment Company Stock, later.

Personal use property. Property held for personal use only, rather than for investment, is a capital asset, and you must report a gain from its sale as a capital gain. However, you cannot deduct a loss from selling personal use property.

Discounted Debt Instruments

Treat your gain or loss on the sale, redemption, or retirement of a bond or other debt instrument originally issued at a discount or bought at a discount as capital gain or loss, except as explained in the following discussions.

Short-term government obligations. Treat gains on short-term federal, state, or local government obligations (other than tax-exempt obligations) as ordinary income up to your ratable share of the acquisition discount. This treatment applies to obligations that have a fixed maturity date not more than 1 year from the date of issue. Acquisition discount is the stated redemption price at maturity minus your basis in the obligation.

However, do not treat these gains as income to the extent you previously included the discount in income. See Discount on Short-Term Obligations in chapter 1 for more information.

Short-term nongovernment obligations. Treat gains on short-term nongovernment obligations as ordinary income up to your ratable share of OID. This treatment applies to obligations that have a fixed maturity date of not more than 1 year from the date of issue.

However, to the extent you previously included the discount in income, you do not have to include it in income again. See Discount on Short-Term Obligations, in chapter 1, for more information.

Tax-exempt state and local government bonds. If these bonds were originally issued at a discount before September 4, 1982, or you acquired them before March 2, 1984, treat your part of the OID as tax-exempt interest. To figure your gain or loss on the sale or trade of these bonds, reduce the amount realized by your part of the OID.

If the bonds were issued after September 3, 1982, and acquired after March 1, 1984, increase the adjusted basis by your part of the OID to figure gain or loss. For more information on the basis of these bonds, see Discounted tax-exempt obligations under Stocks and Bonds, earlier in this chapter.

Any gain from market discount is usually taxable on disposition or redemption of tax-exempt bonds. If you bought the bonds before May 1, 1993, the gain from market discount is capital gain. If you bought the bonds after April 30, 1993, the gain from market discount is ordinary income.

You figure market discount by subtracting the price you paid for the bond from the sum of the original issue price of the bond and the amount of accumulated OID from the date of issue that represented interest to any earlier holders. For more information, see Market Discount Bonds in chapter 1.

A loss on the sale or other disposition of a tax-exempt state or local government bond is deductible as a capital loss.

Redeemed before maturity. If a state or local bond that was issued before June 9, 1980, is redeemed before it matures, the OID is not taxable to you.

If a state or local bond issued after June 8, 1980, is redeemed before it matures, the part of the OID that is earned while you hold the bond is not taxable to you. However, you must report the unearned part of the OID as a capital gain.

Example. On July 1, 1990, the date of issue, you bought a 20-year, 6% municipal bond for $800. The face amount of the bond was $1,000. The $200 discount was OID. At the time the bond was issued, the issuer had no intention of redeeming it before it matured. The bond was callable at its face amount beginning 10 years after the issue date.

The issuer redeemed the bond at the end of 11 years (July 1, 2001) for its face amount of $1,000 plus accrued annual interest of $60. The OID earned during the time you held the bond, $73, is not taxable. The $60 accrued annual interest also is not taxable. However, you must report the unearned part of the OID ($127) as a capital gain.

Long-term debt instruments issued after 1954 and before May 28, 1969 (or before July 2, 1982, if a government instrument). If you sell, trade, or redeem for a gain one of these debt instruments, the part of your gain that is not more than your ratable share of the OID at the time of sale or redemption is ordinary income. The rest of the gain is capital gain. If, however, there was an intention to call the debt instrument before maturity, all of your gain that is not more than the entire OID is treated as ordinary income at the time of the sale. This treatment of taxable gain also applies to corporate instruments issued after May 27, 1969, under a written commitment that was binding on May 27, 1969, and at all times thereafter.

Example. You bought a 30-year, 6% government bond for $700 at original issue on April 1, 1982, and sold it for $900 on April 20, 2001, for a $200 gain. The redemption price is $1,000. At the time of original issue, there was no intention to call the bond before maturity. You have held the bond for 228 full months. Do not count the additional days that are less than a full month. The number of complete months from date of issue to date of maturity is 360 (30 years). The fraction 228/360 multiplied by the discount of $300 ($1,000 - $700) is equal to $190. This is your ratable share of OID for the period you owned the bond. You must treat any part of the gain up to $190 as ordinary income. As a result, $190 is treated as ordinary income and $10 is capital gain.

Long-term debt instruments issued after May 27, 1969 (or after July 1, 1982, if a government instrument). If you hold one of these debt instruments, you must include a part of the OID in your gross income each year that you own the instrument. Your basis in that debt instrument is increased by the amount of OID that you have included in your gross income. See Original Issue Discount (OID) in chapter 1.

If you sell or trade the debt instrument before maturity, your gain is a capital gain. However, if at the time the instrument was originally issued there was an intention to call it before its maturity, your gain generally is ordinary income to the extent of the entire OID reduced by any amounts of OID previously includible in your income. In this case, the rest of the gain is a capital gain.

An intention to call a debt instrument before maturity means there is a written or oral agreement or understanding not provided for in the debt instrument between the issuer and original holder that the issuer will redeem the debt instrument before maturity. In the case of debt instruments that are part of an issue, the agreement or understanding must be between the issuer and the original holders of a substantial amount of the debt instruments in the issue.

Example 1. On February 4, 1999, you bought at original issue for $7,600, Jones Corporation's 10-year, 5% bond which has a stated redemption price at maturity of $10,000. On February 3, 2001, you sold the bond for $9,040. Assume you have included $334 of the OID in your gross income and increased your basis in the bond by that amount. This includes the amount accrued for 2001. Your basis is now $7,934. If at the time of the original issue there was no intention to call the bond before maturity, your gain of $1,106 ($9,040 amount realized minus $7,934 adjusted basis) is capital gain.

Example 2. If, in Example 1, at the time of original issue there was an intention to call the bond before maturity, your entire gain is ordinary income. You figure this as follows:

Because the amount in (3) is more than your gain of $1,106, your entire gain is ordinary income.

Market discount bonds. If the debt instrument has market discount and you chose to include the discount in income as it accrued, increase your basis in the debt instrument by the accrued discount to figure capital gain or loss on its disposition. If you did not choose to include the discount in income as it accrued, you must report gain as ordinary interest income up to the instrument's accrued market discount. See Market Discount Bonds in chapter 1. The rest of the gain is capital gain.

However, a different rule applies if you dispose of a market discount bond that was:

1. Issued before July 19, 1984, and
2. Purchased by you before May 1, 1993.

In that case, any gain is treated as interest income up to the amount of your deferred interest deduction for the year you dispose of the bond. The rest of the gain is capital gain. (Deferred interest deduction for market discount bonds is discussed in chapter 3 under When To Deduct Investment Interest.)

Report the sale or trade of a market discount bond on Schedule D (Form 1040), line 1 or line 8. If the sale or trade results in a gain and you did not choose to include market discount in income currently, enter "Accrued Market Discount" on the next line in column (a) and the amount of the accrued market discount as a loss in column (f). Also report the amount of accrued market discount in column (f) as interest income on Schedule B (Form 1040), line 1, and identify it as "Accrued Market Discount."

Retirement of debt instrument. Any amount that you receive on the retirement of a debt instrument is treated in the same way as if you had sold or traded that instrument.

Notes of individuals. If you hold an obligation of an individual that was issued with OID after March 1, 1984, you generally must include the OID in your income currently, and your gain or loss on its sale or retirement is generally capital gain or loss. An exception to this treatment applies if the obligation is a loan between individuals and all of the following requirements are met.

1. The lender is not in the business of lending money.
2. The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or less.
3. Avoiding federal tax is not one of the principal purposes of the loan.

If the exception applies, or the obligation was issued before March 2, 1984, you do not include the OID in your income currently. When you sell or redeem the obligation, the part of your gain that is not more than your accrued share of the OID at that time is ordinary income. The rest of the gain, if any, is capital gain. Any loss on the sale or redemption is capital loss.

Bearer Obligations

You cannot deduct any loss on an obligation required to be in registered form that is instead held in bearer form. In addition, any gain on the sale or other disposition of the obligation is ordinary income. However, if the issuer was subject to a tax when the obligation was issued, then you can deduct any loss, and any gain may qualify for capital gain treatment.

Obligations required to be in registered form. Any obligation must be in registered form unless:

1. It is issued by a natural person,
2. It is not of a type offered to the public,
3. It has a maturity at the date of issue of not more than 1 year, or
4. It was issued before 1983.

Deposit in Insolvent or Bankrupt Financial Institution

If you lose money you have on deposit in a qualified financial institution that becomes insolvent or bankrupt, you may be able to deduct your loss in one of three ways.

1. Ordinary loss,
2. Casualty loss, or
3. Nonbusiness bad debt (short-term capital loss).

Ordinary loss or casualty loss. If you can reasonably estimate your loss, you can choose to treat the estimated loss as either an ordinary loss or a casualty loss in the current year. Either way, you claim the loss as an itemized deduction.

If you claim an ordinary loss, report it as a miscellaneous itemized deduction on line 22 of Schedule A (Form 1040). The maximum amount you can claim is $20,000 ($10,000 if you are married filing separately) reduced by any expected state insurance proceeds. Your loss is subject to the 2%-of-adjusted-gross-income limit. You cannot choose to claim an ordinary loss if any part of the deposit is federally insured.

If you claim a casualty loss, attach Form 4684, Casualties and Thefts, to your return. Each loss must be reduced by $100. Your total casualty losses for the year are reduced by 10% of your adjusted gross income.

You cannot choose either of these methods if:

1. You own at least 1% of the financial institution,
2. You are an officer of the institution, or
3. You are related to such an owner or officer. You are related if you and the owner or officer are "related parties," as defined earlier under Related Party Transactions, or if you are the aunt, uncle, nephew, or niece of the owner or officer.

If the actual loss that is finally determined is more than the amount you deducted as an estimated loss, you can claim the excess loss as a bad debt. If the actual loss is less than the amount deducted as an estimated loss, you must include in income (in the final determination year) the excess loss claimed. See Recoveries in Publication 525, Taxable and Nontaxable Income.

Nonbusiness bad debt. If you do not choose to deduct your estimated loss as a casualty loss or an ordinary loss, you wait until the year the amount of the actual loss is determined and deduct it as a nonbusiness bad debt in that year. Report it as a short-term capital loss on Schedule D (Form 1040), as explained under Nonbusiness Bad Debts, later.

Sale of Annuity

The part of any gain on the sale of an annuity contract before its maturity date that is based on interest accumulated on the contract is ordinary income.

Conversion Transactions

Generally, all or part of a gain on a conversion transaction is treated as ordinary income. This applies to gain on the disposition or other termination of any position you held as part of a conversion transaction that you entered into after April 30, 1993.

A conversion transaction is any transaction that meets both of these tests.

1. Substantially all of your expected return from the transaction is due to the time value of your net investment. In other words, the return on your investment is, in substance, like interest on a loan.
2. The transaction is one of the following.
1. A straddle as defined under Straddles, later, but including any set of offsetting positions on stock.
2. Any transaction in which you acquire property (whether or not actively traded) at substantially the same time that you contract to sell the same property, or substantially identical property, at a price set in the contract.
3. Any other transaction that is marketed or sold as producing capital gains from a transaction described in (1).

Amount treated as ordinary income. The amount of gain treated as ordinary income is the smaller of:

1. The gain recognized on the disposition or other termination of the position, or
2. The "applicable imputed income amount."

Applicable imputed income amount. Figure this amount as follows.

1. Figure the amount of interest that would have accrued on your net investment in the conversion transaction for the period ending on the earlier of:
1. The date when you dispose of the position, or
2. The date when the transaction stops being a conversion transaction.

To figure this amount, use an interest rate equal to 120% of the "applicable rate," defined later.

2. Subtract from (1) the amount treated as ordinary income from any earlier disposition or other termination of a position held as part of the same conversion transaction.

Applicable rate. If the term of the conversion transaction is indefinite, the applicable rate is the federal short-term rate in effect under section 6621(b) of the Internal Revenue Code during the period of the conversion transaction, compounded daily.

In all other cases, the applicable rate is the "applicable federal rate" determined as if the conversion transaction were a debt instrument and compounded semi-annually.

The rates discussed above are published by the IRS in the Internal Revenue Bulletin. Or, you can contact the IRS to get these rates. See chapter 5 for information on contacting IRS.

Net investment. To determine your net investment in a conversion transaction, include the fair market value of any position at the time it becomes part of the transaction. This means that your net investment generally will be the total amount you invested, less any amount you received for entering into the position (for example, a premium you received for writing a call).

Position with built-in loss. A special rule applies when a position with a built-in loss becomes part of a conversion transaction. A built-in loss is any loss that you would have realized if you had disposed of or otherwise terminated the position at its fair market value at the time it became part of the conversion transaction.

When applying the conversion transaction rules to a position with a built-in loss, use the position's fair market value at the time it became part of the transaction. But, when you dispose of or otherwise terminate the position in a transaction in which you recognize gain or loss, you must recognize the built-in loss. The conversion transaction rules do not affect whether the built-in loss is treated as an ordinary or capital loss.

Netting rule for certain conversion transactions. Before determining the amount of gain treated as ordinary income, you can net certain gains and losses from positions of the same conversion transaction. To do this, you have to dispose of all the positions within a 14-day period that is within a single tax year. You cannot net the built-in loss against the gain.

You can net gains and losses only if you identify the conversion transaction as an identified netting transaction on your books and records. Each position of the conversion transaction must be identified before the end of the day on which the position becomes part of the conversion transaction. For conversion transactions entered into before February 20, 1996, this requirement is met if the identification was made by that date.

Options dealers and commodities traders. These rules do not apply to options dealers and commodities traders.

How to report. Use Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report conversion transactions. See the instructions for lines 11 and 13 of Form 6781.

Commodity Futures

A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price.

If the contract is a regulated futures contract, the rules described earlier under Section 1256 Contracts Marked To Market apply to it.

The termination of a commodity futures contract generally results in capital gain or loss unless the contract is a hedging transaction.

Hedging transaction. A futures contract that is a hedging transaction generally produces ordinary gain or loss. A futures contract is a hedging transaction if you enter into the contract in the ordinary course of your business primarily to manage the risk of interest rate or price changes or currency fluctuations on borrowings, ordinary property, or ordinary obligations. (Generally, ordinary property or obligations are those that cannot produce capital gain or loss under any circumstances.) For example, the offset or exercise of a futures contract that protects against price changes in your business inventory results in an ordinary gain or loss.

For more information about hedging transactions, see section 1.1221-2 of the regulations. Also, see Hedging Transactions under Section 1256 Contracts Marked to Market, earlier.

If you have numerous transactions in the commodity futures market during the year, the burden of proof is on you to show which transactions are hedging transactions. Clearly identify any hedging transactions on your books and records before the end of the day you entered into the transaction. It may be helpful to have separate brokerage accounts for your hedging and nonhedging transactions. For specific requirements concerning identification of hedging transactions and the underlying item, items, or aggregate risk that is being hedged, see section 1.1221-2(e) of the regulations.

Gains From Certain Constructive Ownership Transactions

If you have a gain from a constructive ownership transaction entered into after July 11, 1999, involving a financial asset (discussed later) and the gain normally would be treated as long-term capital gain, all or part of the gain may be treated instead as ordinary income. In addition, if any gain is treated as ordinary income, your tax is increased by an interest charge.

Constructive ownership transactions. The following are constructive ownership transactions.

1. A notional principal contract in which you have the right to receive substantially all of the investment yield on a financial asset and you are obligated to reimburse substantially all of any decline in value of the financial asset.
2. A forward or futures contract to acquire a financial asset.
3. The holding of a call option and writing of a put option on a financial asset at substantially the same strike price and maturity date.

This provision does not apply if all the positions are marked to market. Marked to market rules for section 1256 contracts are discussed in detail under Section 1256 Contracts Marked to Market, earlier.

Financial asset. A financial asset, for this purpose, is any equity interest in a pass-through entity. Pass-through entities include partnerships, S corporations, trusts, regulated investment companies, and real estate investment trusts.

Amount of ordinary income. Long-term capital gain is treated as ordinary income to the extent it is more than the net underlying long-term capital gain. The net underlying long-term capital gain is the amount of net capital gain you would have realized if you acquired the asset for its fair market value on the date the constructive ownership transaction was opened, and sold the asset for its fair market value on the date the transaction was closed. If you do not establish the amount of net underlying long-term capital gain by clear and convincing evidence, it is treated as zero.

More information. For more information, see section 1260 of the Internal Revenue Code.

Losses on Section 1244 (Small Business) Stock

You can deduct as an ordinary loss, rather than as a capital loss, a loss on the sale, trade, or worthlessness of section 1244 stock. Report the loss on Form 4797, Sales of Business Property, line 10.

Any gain on section 1244 stock is a capital gain if the stock is a capital asset in your hands. Do not offset gains against losses that are within the ordinary loss limit, explained later in this discussion, even if the transactions are in stock of the same company. Report the gain on Schedule D of Form 1040.

If you must figure a net operating loss, any ordinary loss from the sale of section 1244 stock is a business loss.

Ordinary loss limit. The amount that you can deduct as an ordinary loss is limited to $50,000 each year. On a joint return the limit is $100,000, even if only one spouse has this type of loss. If your loss is $110,000 and your spouse has no loss, you can deduct $100,000 as an ordinary loss on a joint return. The remaining $10,000 is a capital loss.

Section 1244 (small business) stock. This is stock that was issued for money or property (other than stock and securities) in a domestic small business corporation. During its 5 most recent tax years before the loss, this corporation must have derived more than 50% of its gross receipts from other than royalties, rents, dividends, interest, annuities, and gains from sales and trades of stocks or securities. If the corporation was in existence for at least 1 year, but less than 5 years, the 50% test applies to the tax years ending before the loss. If the corporation was in existence less than 1 year, the 50% test applies to the entire period the corporation was in existence before the day of the loss. However, if the corporation's deductions (other than the net operating loss and dividends received deductions) were more than its gross income during this period, this 50% test does not apply.

The corporation must have been largely an operating company for ordinary loss treatment to apply.

If the stock was issued before July 19, 1984, the stock must be common stock. If issued after July 18, 1984, the stock may be either common or preferred. For more information about the requirements of a small business corporation or the qualifications of section 1244 stock, see section 1244 of the Internal Revenue Code and its regulations.

The stock must be issued to the person taking the loss. You must be the original owner of the stock to be allowed ordinary loss treatment. To claim a deductible loss on stock issued to your partnership, you must have been a partner when the stock was issued and have remained so until the time of the loss. You add your distributive share of the partnership loss to any individual section 1244 stock loss you may have before applying the ordinary loss limit.

Stock distributed by partnership. If your partnership distributes the stock to you, you cannot treat any later loss on that stock as an ordinary loss.

Stock sold through underwriter. Stock sold through an underwriter is not section 1244 stock unless the underwriter only acted as a selling agent for the corporation.

Stock dividends and reorganizations. Stock you receive as a stock dividend qualifies as section 1244 stock if:

1. You receive it from a small business corporation in which you own stock, and
2. The stock you own meets the requirements when the stock dividend is distributed.

If you trade your section 1244 stock for new stock in the same corporation in a reorganization that qualifies as a recapitalization or that is only a change in identity, form, or place of organization, the new stock is section 1244 stock if the stock you trade meets the requirements when the trade occurs.

If you hold section 1244 stock and other stock in the same corporation, not all of the stock you receive as a stock dividend or in a reorganization will qualify as section 1244 stock. Only that part based on the section 1244 stock you hold will qualify.

Example. Your basis for 100 shares of X common stock is $1,000. These shares qualify as section 1244 stock. If, as a nontaxable stock dividend, you receive 50 more shares of common stock, the basis of which is determined from the 100 shares you own, the 50 shares are also section 1244 stock.

If you also own stock in the corporation that is not section 1244 stock when you receive the stock dividend, you must divide the shares you receive as a dividend between the section 1244 stock and the other stock. Only the shares from the former can be section 1244 stock.

Contributed property. To determine ordinary loss on section 1244 stock you receive in a trade for property, you have to reduce the basis of the stock if:

1. The adjusted basis (for figuring loss) of the property, immediately before the trade, was more than its fair market value, and
2. The basis of the stock is determined by the basis of the property.

Reduce the basis of the stock by the difference between the adjusted basis of the property and its fair market value at the time of the trade. You reduce the basis only to figure the ordinary loss. Do not reduce the basis of the stock for any other purpose.

Example. You transfer property with an adjusted basis of $1,000 and a fair market value of $250 to a corporation for its section 1244 stock. The basis of your stock is $1,000, but to figure the ordinary loss under these rules, the basis of your stock is $250 ($1,000 minus $750). If you later sell the section 1244 stock for $200, your $800 loss is an ordinary loss of $50 and a capital loss of $750.

Contributions to capital. If the basis of your section 1244 stock has increased, through contributions to capital or otherwise, you must treat this increase as applying to stock that is not section 1244 stock when you figure an ordinary loss on its sale.

Example. You buy 100 shares of section 1244 stock for $10,000. You are the original owner. You later make a $2,000 contribution to capital that increases the total basis of the 100 shares to $12,000. You then sell the 100 shares for $9,000 and have a loss of $3,000. You can deduct only $2,500 ($3,000 × $10,000/$12,000) as an ordinary loss under these rules. The remaining $500 is a capital loss.

Recordkeeping. You must keep records sufficient to show your stock qualifies as section 1244 stock. Your records must also distinguish your section 1244 stock from any other stock you own in the corporation.

Losses on Small Business Investment Company Stock

A small business investment company (SBIC) is one that is licensed and operated under the Small Business Investment Act of 1958.

If you are an investor in SBIC stock, you can deduct as an ordinary loss, rather than a capital loss, a loss from the sale, trade, or worthlessness of that stock. A gain from the sale or trade of that stock is a capital gain. Do not offset your gains and losses, even if they are on stock of the same company.

How to report. You report this type of ordinary loss on line 10, Part II, of Form 4797. In addition to the information required by the form, you must include the name and address of the company that issued the stock. Report a capital gain from the sale of SBIC stock on Schedule D of Form 1040.

Short sale. If you close a short sale of SBIC stock with other SBIC stock that you bought only for that purpose, any loss you have on the sale is a capital loss. See Short Sales, later in this chapter, for more information.

Holding Period

If you sold or traded investment property, you must determine your holding period for the property. Your holding period determines whether any capital gain or loss was a short-term or a long-term capital gain or loss.

Long-term or short-term. If you hold investment property more than 1 year, any capital gain or loss is a long-term capital gain or loss. If you hold the property 1 year or less, any capital gain or loss is a short-term capital gain or loss.

To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.

Example. If you bought investment property on February 5, 2000, and sold it on February 5, 2001, your holding period is not more than 1 year and you have a short-term capital gain or loss. If you sold it on February 6, 2001, your holding period is more than 1 year and you have a long-term capital gain or loss.

Securities traded on an established market. For securities traded on an established securities market, your holding period begins the day after the trade date you bought the securities, and ends on the trade date you sold them.

Do not confuse the trade date with the settlement date, which is the date by which the stock must be delivered and payment must be made.

Example. You are a cash method, calendar year taxpayer. You sold stock at a gain on December 28, 2001. According to the rules of the stock exchange, the sale was closed by delivery of the stock 3 trading days after the sale, on January 3, 2002. You received payment of the sale price on that same day. Report your gain on your 2001 return, even though you received the payment in 2002. The gain is long term or short term depending on whether you held the stock more than 1 year. Your holding period ended on December 28. If you had sold the stock at a loss, you would also report it on your 2001 return.

U.S. Treasury notes and bonds. The holding period of U.S. Treasury notes and bonds sold at auction on the basis of yield starts the day after the Secretary of the Treasury, through news releases, gives notification of acceptance to successful bidders. The holding period of U.S. Treasury notes and bonds sold through an offering on a subscription basis at a specified yield starts the day after the subscription is submitted.

Automatic investment service. In determining your holding period for shares bought by the bank or other agent, full shares are considered bought first and any fractional shares are considered bought last. Your holding period starts on the day after the bank's purchase date. If a share was bought over more than one purchase date, your holding period for that share is a split holding period. A part of the share is considered to have been bought on each date that stock was bought by the bank with the proceeds of available funds.

Nontaxable trades. If you acquire investment property in a trade for other investment property and your basis for the new property is determined, in whole or in part, by your basis in the old property, your holding period for the new property begins on the day following the date you acquired the old property.

Property received as a gift. If you receive a gift of property and your basis is determined by the donor's adjusted basis, your holding period is considered to have started on the same day the donor's holding period started.

If your basis is determined by the fair market value of the property, your holding period starts on the day after the date of the gift.

Inherited property. If you inherit investment property, your capital gain or loss on any later disposition of that property is treated as a long-term capital gain or loss. This is true regardless of how long you actually held the property.

Real property bought. To figure how long you have held real property bought under an unconditional contract, begin counting on the day after you received title to it or on the day after you took possession of it and assumed the burdens and privileges of ownership, whichever happened first. However, taking delivery or possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time.

Real property repossessed. If you sell real property but keep a security interest in it, and then later repossess the property under the terms of the sales contract, your holding period for a later sale includes the period you held the property before the original sale and the period after the repossession. Your holding period does not include the time between the original sale and the repossession. That is, it does not include the period during which the first buyer held the property.

Stock dividends. The holding period for stock you received as a taxable stock dividend begins on the date of distribution.

The holding period for new stock you received as a nontaxable stock dividend begins on the same day as the holding period of the old stock. This rule also applies to stock acquired in a spin-off, which is a distribution of stock or securities in a controlled corporation.

Nontaxable stock rights. Your holding period for nontaxable stock rights begins on the same day as the holding period of the underlying stock. The holding period for stock acquired through the exercise of stock rights begins on the date the right was exercised.

Section 1256 contracts. Gains or losses on section 1256 contracts open at the end of the year, or terminated during the year, are treated as 60% long term and 40% short term, regardless of how long the contracts were held. See Section 1256 Contracts Marked to Market, earlier.

Option exercised. Your holding period for property you acquire when you exercise an option begins the day after you exercise the option.

Wash sales. Your holding period for substantially identical stock or securities you acquire in a wash sale includes the period you held the old stock or securities.

Qualified small business stock. Your holding period for stock you acquired in a tax-free rollover of gain from a sale of qualified small business stock, described later, includes the period you held the old stock.

Commodity or securities futures. Futures transactions in any commodity subject to the rules of a board of trade or commodity exchange are long term if the contract was held for more than 6 months.

Your holding period for a commodity received in satisfaction of a commodity futures contract or securities futures contract, other than a regulated futures contract subject to Internal Revenue Code section 1256, includes your holding period for the futures contract if you held the contract as a capital asset.

Securities futures contract. Your holding period for a security received in satisfaction of a securities futures contract, other than one that is a section 1256 contract, includes your holding period for the futures contract if you held the contract as a capital asset.

Loss on mutual fund or REIT stock held 6 months or less. If you hold stock in a regulated investment company (commonly called a mutual fund) or real estate investment trust (REIT) for 6 months or less and then sell it at a loss (other than under a periodic liquidation plan), special rules may apply.

Capital gain distributions received. The loss (after reduction for any exempt-interest dividends you received, as explained next) is treated as a long-term capital loss up to the total of any capital gain distributions you received and your share of any undistributed capital gains. Any remaining loss is short-term capital loss.

Exempt-interest dividends on mutual fund stock. If you received exempt-interest dividends on the stock, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends.

Nonbusiness Bad Debts

If someone owes you money that you cannot collect, you have a bad debt. You may be able to deduct the amount owed to you when you figure your tax for the year the debt becomes worthless.

There are two kinds of bad debts -- business and nonbusiness. A business bad debt, generally, is one that comes from operating your trade or business and is deductible as a business loss. All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses.

Example. An architect made personal loans to several friends who were not clients. She could not collect on some of these loans. They are deductible only as nonbusiness bad debts because the architect was not in the business of lending money and the loans do not have any relationship to her business.

Business bad debts. For information on business bad debts of an employee, see Publication 529. For information on other business bad debts, see chapter 11 of Publication 535.

Deductible nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.

Genuine debt required. A debt must be genuine for you to deduct a loss. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

Loan or gift. For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or organization that owes you the money.

When minor children borrow from their parents to pay for their basic needs, there is no genuine debt. A bad debt cannot be deducted for such a loan.

Basis in bad debt required. To deduct a bad debt, you must have a basis in it -- that is, you must have already included the amount in your income or loaned out your cash. For example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. If you are a cash method taxpayer (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

When deductible. You can take a bad debt deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance that the amount owed will be paid.

It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.

If your bad debt is the loss of a deposit in a financial institution, see Deposit in Insolvent or Bankrupt Financial Institution, earlier.

Filing a claim for refund. If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt. To do this, use Form 1040X to amend your return for the year the debt became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. (Claims not due to bad debts or worthless securities generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

Loan guarantees. If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either that your reason for making the guarantee was to protect your investment or that you entered the guarantee transaction with a profit motive. If you make the guarantee as a favor to friends and do not receive any consideration in return, your payments are considered a gift and you cannot take a deduction.

Example 1. Henry Lloyd, an officer and principal shareholder of the Spruce Corporation, guaranteed payment of a bank loan the corporation received. The corporation defaulted on the loan and Henry made full payment. Because he guaranteed the loan to protect his investment in the corporation, Henry can take a nonbusiness bad debt deduction.

Example 2. Milt and John are co-workers. Milt, as a favor to John, guarantees a note at their local credit union. John does not pay the note and declares bankruptcy. Milt pays off the note. However, since he did not enter into the guarantee agreement to protect an investment or to make a profit, Milt cannot take a bad debt deduction.

Deductible in year paid. Unless you have rights against the borrower, discussed next, a payment you make on a loan you guaranteed is deductible in the year you make the payment.

Rights against the borrower. When you make payment on a loan that you guaranteed, you may have the right to take the place of the lender (the right of subrogation). The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you cannot take a bad debt deduction until these rights become totally worthless.

Debts owed by political parties. You cannot take a nonbusiness bad debt deduction for any worthless debt owed to you by:

1. A political party,
2. A national, state, or local committee of a political party, or
3. A committee, association, or organization that either accepts contributions or spends money to influence elections.

Mechanics' and suppliers' liens. Workers and material suppliers may file liens against property because of debts owed by a builder or contractor. If you pay off the lien to avoid foreclosure and loss of your property, you are entitled to repayment from the builder or contractor. If the debt is uncollectible, you can take a bad debt deduction.

Insolvency of contractor. You can take a bad debt deduction for the amount you deposit with a contractor if the contractor becomes insolvent and you are unable to recover your deposit. If the deposit is for work unrelated to your trade or business, it is a nonbusiness bad debt deduction.

Secondary liability on home mortgage. If the buyer of your home assumes your mortgage, you may remain secondarily liable for repayment of the mortgage loan. If the buyer defaults on the loan and the house is then sold for less than the amount outstanding on the mortgage, you may have to make up the difference. You can take a bad debt deduction for the amount you pay to satisfy the mortgage, if you cannot collect it from the buyer.

Worthless securities. If you own securities that become totally worthless, you can take a deduction for a loss, but not for a bad debt. See Worthless Securities under What Is a Sale or Trade, earlier in this chapter.

Recovery of a bad debt. If you deducted a bad debt and in a later tax year you recover (collect) all or part of it, you may have to include the amount you recover in your gross income. However, you can exclude from gross income the amount recovered up to the amount of the deduction that did not reduce your tax in the year deducted. See Recoveries in Publication 525.

How to report bad debts. Deduct nonbusiness bad debts as short-term capital losses on Schedule D (Form 1040).

In Part I, line 1 of Schedule D, enter the name of the debtor and "statement attached" in column (a). Enter the amount of the bad debt in parentheses in column (f). Use a separate line for each bad debt.

For each bad debt, attach a statement to your return that contains:

1. A description of the debt, including the amount, and the date it became due,
2. The name of the debtor, and any business or family relationship between you and the debtor,
3. The efforts you made to collect the debt, and
4. Why you decided the debt was worthless. For example, you could show that the borrower has declared bankruptcy, or that legal action to collect would probably not result in payment of any part of the debt.

S corporation shareholder. If you are a shareholder in an S corporation, your share of any nonbusiness bad debt will be shown on a schedule attached to your Schedule K-1 (Form 1120S) that you receive from the corporation.

Short Sales

A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of sale in two steps.

1. You sell short. You borrow property and deliver it to a buyer.
2. You close the sale. At a later date, you either buy substantially identical property and deliver it to the lender or make delivery out of property that you held at the time of the sale.

You do not realize gain or loss until delivery of property to close the short sale. You will have a capital gain or loss if the property used to close the short sale is a capital asset.

Exception if property becomes worthless. A different rule applies if the property sold short becomes substantially worthless. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.

Exception for constructive sales. Entering into a short sale may cause you to be treated as having made a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. For details, see Constructive Sales of Appreciated Financial Positions, earlier.

Example. On May 1, 2001, you bought 100 shares of Baker Corporation stock for $1,000. On September 3, 2001, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2001 and the first 30 days of 2002. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins on September 3.

Short-Term or Long-Term Capital Gain or Loss

As a general rule, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount of time you actually hold the property eventually delivered to the lender to close the short sale.

Example. Even though you do not own any stock of the Ace Corporation, you contract to sell 100 shares of it, which you borrow from your broker. After 13 months, when the price of the stock has risen, you buy 100 shares of Ace Corporation stock and immediately deliver them to your broker to close out the short sale. Your loss is a short-term capital loss because your holding period for the delivered property is less than one day.

Special rules. Special rules may apply to gains and losses from short sales of stocks, securities, and commodity futures (other than certain straddles) if you held or acquired property substantially identical property to that sold short. But if the amount of property you sold short is more than the amount of that substantially identical property, the special rules do not apply to the gain or loss on the excess.

Gains and holding period. If you held the substantially identical property for 1 year or less on the date of the short sale, or if you acquired the substantially identical property after the short sale and by the date of closing the short sale, then:

• Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain, and
• Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.

Losses. If, on the date of the short sale, you held substantially identical property for more than 1 year, any loss you realize on the short sale is a long-term capital loss, even if you held the property used to close the sale for 1 year or less. Certain losses on short sales of stock or securities are also subject to wash sale treatment. For information, see Wash Sales, later.

Mixed straddles. Under certain elections, you can avoid the treatment of loss from a short sale as long term under the special rule. These elections are for positions that are part of a mixed straddle. See Other elections under Mixed Straddles, later, for more information about these elections.

Reporting Substitute Payments

If any broker transferred your securities for use in a short sale, or similar transaction, and received certain substitute dividend payments on your behalf while the short sale was open, that broker must give you a Form 1099-MISC or a similar statement, reporting the amount of these payments. Form 1099-MISC must be used for those substitute payments totaling $10 or more that are known on the payment's record date to be in lieu of an exempt-interest dividend, a capital gain dividend, a return of capital distribution, or a dividend subject to a foreign tax credit, or that are in lieu of tax-exempt interest. Do not treat these substitute payments as dividends or interest. Instead, report the substitute payments shown on Form 1099-MISC as "Other income" on line 21 of Form 1040.

Substitute payment. A substitute payment means a payment in lieu of:

1. Tax-exempt interest (including OID) that has accrued while the short sale was open, and
2. A dividend, if the ex-dividend date is after the transfer of stock for use in a short sale and before the closing of the short sale.

Short Sale Expenses

If you borrow stock to make a short sale, you may have to remit to the lender payments in lieu of the dividends distributed while you maintain your short position. You can deduct these payments only if you hold the short sale open at least 46 days (more than 1 year in the case of an extraordinary dividend as defined below) and you itemize your deductions.

You deduct these expenses as investment interest on Schedule A (Form 1040). See Interest Expenses in chapter 3 for more information.

If you close the short sale by the 45th day after the date of the short sale (1 year or less in the case of an extraordinary dividend), you cannot deduct the payment in lieu of the dividend that you make to the lender. Instead, you must increase the basis of the stock used to close the short sale by that amount.

To determine how long a short sale is kept open, do not include any period during which you hold, have an option to buy, or are under a contractual obligation to buy substantially identical stock or securities.

If your payment is made for a liquidating distribution or nontaxable stock distribution, or if you buy more shares equal to a stock distribution issued on the borrowed stock during your short position, you have a capital expense. You must add the payment to the cost of the stock sold short.

Exception. If you close the short sale within 45 days, the deduction for amounts you pay in lieu of dividends will be disallowed only to the extent the payments are more than the amount that you receive as ordinary income from the lender of the stock for the use of collateral with the short sale. This exception does not apply to payments in place of extraordinary dividends.

Extraordinary dividends. If the amount of any dividend you receive on a share of preferred stock equals or exceeds 5% (10% in the case of other stock) of the amount realized on the short sale, the dividend you receive is an extraordinary dividend.

Wash Sales

You cannot deduct losses from sales or trades of stock or securities in a wash sale.

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

1. Buy substantially identical stock or securities,
2. Acquire substantially identical stock or securities in a fully taxable trade, or
3. Acquire a contract or option to buy substantially identical stock or securities.

If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities. The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities begins on the same day as the holding period of the stock or securities sold.

Example 1. You buy 100 shares of X stock for $1,000. You sell these shares for $750 and within 30 days from the sale you buy 100 shares of the same stock for $800. Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale. However, you add the disallowed loss of $250 to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.

Example 2. You are an employee of a corporation that has an incentive pay plan. Under this plan, you are given 10 shares of the corporation's stock as a bonus award. You include the fair market value of the stock in your gross income as additional pay. You later sell these shares at a loss. If you receive another bonus award of substantially identical stock within 30 days of the sale, you cannot deduct your loss on the sale.

Options and futures contracts. The wash sale rules apply to losses from sales or trades of contracts and options to acquire or sell stock or securities. They do not apply to losses from sales or trades of commodity futures contracts and foreign currencies. See Coordination of Loss Deferral Rules and Wash Sale Rules under Straddles, later, for information about the tax treatment of losses on the disposition of positions in a straddle.

Warrants. The wash sale rules apply if you sell common stock at a loss and, at the same time, buy warrants for common stock of the same corporation. But if you sell warrants at a loss and, at the same time, buy common stock in the same corporation, the wash sale rules apply only if the warrants and stock are considered substantially identical, as discussed next.

Substantially identical. In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.

Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock:

1. Is convertible into common stock,
2. Has the same voting rights as the common stock,
3. Is subject to the same dividend restrictions,
4. Trades at prices that do not vary significantly from the conversion ratio, and
5. Is unrestricted as to convertibility.

More or less stock bought than sold. If the number of shares of substantially identical stock or securities you buy within 30 days before or after the sale is either more or less than the number of shares you sold, you must determine the particular shares to which the wash sale rules apply. You do this by matching the shares bought with an equal number of the shares sold. Match the shares bought in the same order that you bought them, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.

Example 1. You bought 100 shares of M stock on September 24, 2000, for $5,000. On December 21, 2000, you bought 50 shares of substantially identical stock for $2,750. On December 28, 2000, you bought 25 shares of substantially identical stock for $1,125. On January 4, 2001, you sold for $4,000 the 100 shares you bought in September. You have a $1,000 loss on the sale. However, because you bought 75 shares of substantially identical stock within 30 days of the sale, you cannot deduct the loss ($750) on 75 shares. You can deduct the loss ($250) on the other 25 shares. The basis of the 50 shares bought on December 21, 2000, is increased by two-thirds (50 × 75) of the $750 disallowed loss. The new basis of those shares is $3,250 ($2,750 + $500). The basis of the 25 shares bought on December 28, 2000, is increased by the rest of the loss to $1,375 ($1,125 + $250).

Example 2. You bought 100 shares of M stock on September 24, 2000. On February 1, 2001, you sold those shares at a $1,000 loss. On each of the 4 days from February 13, 2001, to February 16, 2001, you bought 50 shares of substantially identical stock. You cannot deduct your $1,000 loss. You must add half the disallowed loss ($500) to the basis of the 50 shares bought on February 13. Add the other half ($500) to the basis of the shares bought on February 14.

Loss and gain on same day. Loss from a wash sale of one block of stock or securities cannot be used to reduce any gains on identical blocks sold the same day.

Example. During 1996, you bought 100 shares of X stock on each of three occasions. You paid $158 a share for the first block of 100 shares, $100 a share for the second block, and $95 a share for the third block. On December 23, 2001, you sold 300 shares of X stock for $125 a share. On January 6, 2002, you bought 250 shares of identical X stock. You cannot deduct the loss of $33 a share on the first block because within 30 days after the date of sale you bought 250 identical shares of X stock. In addition, you cannot reduce the gain realized on the sale of the second and third blocks of stock by this loss.

Dealers. The wash sale rules do not apply to a dealer in stock or securities if the loss is from a transaction made in the ordinary course of business.

Short sales. The wash sale rules apply to a loss realized on a short sale if you sell, or enter into another short sale of, substantially identical stock or securities within a period beginning 30 days before the date the short sale is complete and ending 30 days after that date.

For purposes of the wash sale rules, a short sale is considered complete on the date the short sale is entered into, if:

1. On that date, you own stock or securities identical to those sold short (or by that date you enter into a contract or option to acquire that stock or those securities), and
2. You later deliver the stock or securities to close the short sale.

Otherwise, a short sale is not considered complete until the property is delivered to close the sale.

Example. On June 2, you buy 100 shares of stock for $1,000. You sell short 100 shares of the stock for $750 on October 6. On October 7, you buy 100 shares of the same stock for $750. You close the short sale on November 17 by delivering the shares bought on June 2. You cannot deduct the $250 loss ($1,000 - $750) because the date of entering into the short sale (October 6) is considered the date the sale is complete for wash sale purposes and you bought substantially identical stock within 30 days from that date.

Residual Interests in a REMIC. The wash sale rules generally will apply to the sale of your residual interest in a real estate mortgage investment conduit (REMIC) if, during the period beginning 6 months before the sale of the interest and ending 6 months after that sale, you acquire any residual interest in any REMIC or any interest in a taxable mortgage pool that is comparable to a residual interest. REMICs are discussed in chapter 1.

How to report. Report a wash sale or trade on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. Show the full amount of the loss in parentheses in column (f). On the next line, enter "Wash Sale" in column (a) and the amount of the loss not allowed as a positive amount in column (f).

Securities Futures Contracts

A securities futures contract is a contract of sale for future delivery of a single security or of a narrow-based security index.

Gain or loss from the contract generally will be treated in a manner similar to gain or loss from transactions in the underlying security. This means gain or loss from the sale or exchange of the contract will generally have the same character as gain or loss from transactions in the property to which the contract relates. Any capital gain or loss on a sale or exchange of a contract to sell property will be considered short-term, regardless of how long you hold the contract. These contracts are not section 1256 contracts (unless they are dealer securities futures contracts).

Options

Options are generally subject to the rules described in this section. If the option is part of a straddle, the loss deferral rules covered later under Straddles may also apply. For special rules that apply to nonequity options and dealer equity options, see Section 1256 Contracts Marked to Market, earlier.

Gain or loss from the sale or trade of an option to buy or sell property that is a capital asset in your hands, or would be if you acquired it, is capital gain or loss. If the property is not, or would not be, a capital asset, the gain or loss is ordinary gain or loss.

Example 1. You purchased an option to buy 100 shares of XYZ Company stock. The stock increases in value and you sell the option for more than you paid for it. Your gain is capital gain because the stock underlying the option would have been a capital asset in your hands.

Example 2. The facts are the same as in Example 1, except that the stock decreases in value and you sell the option for less than you paid for it. Your loss is a capital loss.

Option not exercised. If you have a loss because you did not exercise an option to buy or sell, you are considered to have sold or traded the option on the date that it expired.

Writer of option. If you write (grant) an option, how you report your gain or loss depends on whether it was exercised.

If you are not in the business of writing options and an option you write on stocks, securities, commodities, or commodity futures is not exercised, the amount you receive is a short-term capital gain.

If an option requiring you to buy or sell property is exercised, see Writers of calls and puts, later.

Section 1256 contract options. Gain or loss is recognized on the exercise of an option on a section 1256 contract. Section 1256 contracts are defined under Section 1256 Contracts Marked to Market, earlier.

Cash settlement option. A cash settlement option is treated as an option to buy or sell property. A cash settlement option is any option that on exercise is settled in, or could be settled in, cash or property other than the underlying property.

How to report. Gain or loss from the closing or expiration of an option that is not a section 1256 contract, but that is a capital asset in your hands, is reported on Schedule D (Form 1040).

If an option you purchased expired, enter the expiration date in column (c) and write "Expired" in column (d).

If an option that you wrote expired, enter the expiration date in column (b) and write "Expired" in column (e).

Calls and Puts

Calls and puts are options on securities and are covered by the rules just discussed for options. The following are specific applications of these rules to holders and writers of options that are bought, sold, or "closed out" in transactions on a national securities exchange, such as the Chicago Board Options Exchange. (But see Section 1256 Contracts Marked to Market, earlier, for special rules that may apply to nonequity options and dealer equity options.) These rules are also presented in Table 4-1.

Calls and puts are issued by writers (grantors) to holders for cash premiums. They are ended by exercise, closing transaction, or lapse.

A call option is the right to buy from the writer of the option, at any time before a specified future date, a stated number of shares of stock at a specified price. Conversely, a put option is the right to sell to the writer, at any time before a specified future date, a stated number of shares at a specified price.

Holders of calls and puts. If you buy a call or a put, you may not deduct its cost. It is a capital expenditure.

If you sell the call or the put before you exercise it, the difference between its cost and the amount you receive for it is either a long-term or short-term capital gain or loss, depending on how long you held it.

If the option expires, its cost is either a long-term or short-term capital loss, depending on your holding period, which ends on the expiration date.

If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock.

Put option as short sale. Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. See Short Sales, earlier. If you have held the underlying stock for 1 year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration. Your holding period for the underlying stock begins on the earliest of:

1. The date you dispose of the stock,
2. The date you exercise the put,
3. The date you sell the put, or
4. The date the put expires.

Writers of calls and puts. If you write (grant) a call or a put, do not include the amount you receive for writing it in your income at the time of receipt. Carry it in a deferred account until:

1. Your obligation expires,
2. You sell, in the case of a call, or buy, in the case of a put, the underlying stock when the option is exercised, or
3. You engage in a closing transaction.

If your obligation expires, the amount you received for writing the call or put is short-term capital gain.

If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss. The gain or loss is long term or short term depending on your holding period of the stock.

If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put. Your holding period for the stock begins on the date you buy it, not on the date you wrote the put.

If you enter into a closing transaction by paying an amount equal to the value of the call or put at the time of the payment, the difference between the amount you pay and the amount you receive for the call or put is a short-term capital gain or loss.

Examples of non-dealer transactions.

1. Expiration. Ten JJJ call options were issued on April 8, 2001, for $4,000. These equity options expired in December 2001, without being exercised. If you were a holder (buyer) of the options, you would recognize a short-term capital loss of $4,000. If you were a writer of the options, you would recognize a short-term capital gain of $4,000.
2. Closing transaction. The facts are the same as in (1), except that on May 10, 2001, the options were sold for $6,000. If you were the holder of the options who sold them, you would recognize a short-term capital gain of $2,000. If you were the writer of the options and you bought them back, you would recognize a short-term capital loss of $2,000.
3. Exercise. The facts are the same as in (1), except that the options were exercised on May 27, 2001. The buyer adds the cost of the options to the basis of the stock bought through the exercise of the options. The writer adds the amount received from writing the options to the amount realized from selling the stock.
4. Section 1256 contracts. The facts are the same as in (1), except the options were nonequity options, subject to the rules for section 1256 contracts. If you were a buyer of the options, you would recognize a short-term capital loss of $1,600, and a long-term capital loss of $2,400. If you were a writer of the options, you would recognize a short-term capital gain of $1,600, and a long-term capital gain of $2,400. See Section 1256 Contracts Marked to Market, earlier, for more information.

Table 4-1 Puts and Calls

Straddles

This section discusses the loss deferral rules that apply to the sale or other disposition of positions in a straddle. These rules do not apply to the straddles described under Exceptions, later.

A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a security and a written option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period.

Personal property. This is any property of a type that is actively traded. It includes stock options and contracts to buy stock, but generally does not include stock.

Straddle rules for stock. Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations.

1. The stock is part of a straddle in which at least one of the offsetting positions is either:
1. An option to buy or sell the stock or substantially identical stock or securities,
2. A securities futures contract on the stock or substantially identical stock or securities, or
3. A position on substantially similar or related property (other than stock).
2. The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.

Position. A position is an interest in personal property. A position can be a forward or futures contract, or an option.

An interest in a loan that is denominated in a foreign currency is treated as a position in that currency. For the straddle rules, foreign currency for which there is an active interbank market is considered to be actively-traded personal property. See also Foreign currency contract under Section 1256 Contracts Marked to Market, earlier.

Offsetting position. This is a position that substantially reduces any risk of loss you may have from holding another position. However, if a position is part of a straddle that is not an identified straddle (described later), do not treat it as offsetting to a position that is part of an identified straddle.

Presumed offsetting positions. If you establish two or more positions, an offsetting position will be presumed under any of the following conditions, unless otherwise rebutted.

1. The positions are established in the same personal property (or in a contract for this property), and the value of one or more positions varies inversely with the value of one or more of the other positions.
2. The positions are in the same personal property, even if this property is in a substantially changed form, and the positions' values vary inversely as described in the first condition.
3. The positions are in debt instruments with a similar maturity, and the positions' values vary inversely as described in the first condition.
4. The positions are sold or marketed as offsetting positions, whether or not the positions are called a straddle, spread, butterfly, or any similar name.
5. The aggregate margin requirement for the positions is lower than the sum of the margin requirements for each position if held separately.

Related persons. To determine if two or more positions are offsetting, you will be treated as holding any position that your spouse holds during the same period. If you take into account part or all of the gain or loss for a position held by a flowthrough entity, such as a partnership or trust, you are also considered to hold that position.

Loss Deferral Rules

Generally, you can deduct a loss on the disposition of one or more positions only to the extent that the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.

Unrecognized gain. This is:

1. The amount of gain you would have had on an open position if you had sold it on the last business day of the tax year at its fair market value, and
2. The amount of gain realized on a position if, as of the end of the tax year, gain has been realized, but not recognized.

Example. On July 1, 2001, you entered into a straddle. On December 16, 2001, you closed one position of the straddle at a loss of $15,000. On December 31, 2001, the end of your tax year, you have an unrecognized gain of $12,750 in the offsetting open position. On your 2001 return, your deductible loss on the position you closed is limited to $2,250 ($15,000 - $12,750). You must carry forward to 2002 the unused loss of $12,750.

Exceptions. The loss deferral rules do not apply to:

1. A straddle that is an identified straddle at the end of the tax year,
2. Certain straddles consisting of qualified covered call options and the stock to be purchased under the options,
3. Hedging transactions, described earlier under Section 1256 Contracts Marked to Market, and
4. Straddles consisting entirely of section 1256 contracts, as described earlier under Section 1256 Contracts Marked to Market (but see Identified straddle, next).

Identified straddle. Losses from positions in an identified straddle are deferred until you dispose of all the positions in the straddle.

Any straddle (other than a straddle described in (2) or (3) above) is an identified straddle if all of the following conditions exist.

1. You clearly identified the straddle on your records before the close of the day on which you acquired it.
2. All of the original positions that you identify were acquired on the same day.
3. All of the positions included in item (2) were disposed of on the same day during the tax year, or none of the positions were disposed of by the end of the tax year.
4. The straddle is not part of a larger straddle.

Qualified covered call options and optioned stock. A straddle is not subject to the loss deferral rules for straddles if both of the following are true.

1. All of the offsetting positions consist of one or more qualified covered call options and the stock to be purchased from you under the options.
2. The straddle is not part of a larger straddle.

But see Special year-end rule, later, for an exception.

A qualified covered call option is any option you grant to purchase stock you hold (or stock you acquire in connection with granting the option), but only if all of the following are true.

1. The option is traded on a national securities exchange or other market approved by the Secretary of the Treasury.
2. The option is granted more than 30 days before its expiration date.
3. The option is not a deep-in-the-money option.
4. You are not an options dealer who granted the option in connection with your activity of dealing in options.
5. Gain or loss on the option is capital gain or loss.

A deep-in-the-money option is an option with a strike price lower than the lowest qualified benchmark (LQB). The strike price is the price at which the option is to be exercised. The LQB is the highest available strike price that is less than the applicable stock price. However, the LQB for an option with a term of more than 90 days and a strike price of more than $50 is the second highest available strike price that is less than the applicable stock price. Strike prices are listed in the financial section of many newspapers.

The availability of strike prices for equity options with flexible terms does not affect the determination of the LQB for an option that is not an equity option with flexible terms.

The applicable stock price for any stock for which an option has been granted is:

1. The closing price of the stock on the most recent day on which that stock was traded before the date on which the option was granted, or
2. The opening price of the stock on the day on which the option was granted, but only if that price is greater than 110% of the price determined in (1).

If the applicable stock price is $25 or less, the LQB will be treated as not less than 85% of the applicable stock price. If the applicable stock price is $150 or less, the LQB will be treated as not less than an amount that is $10 below the applicable stock price.

Example. On May 13, 2001, you held XYZ stock and you wrote an XYZ/September call option with a strike price of $120. The closing price of one share of XYZ stock on May 12, 2001, was $130.25. The strike prices of all XYZ/September call options offered on May 13, 2001, were as follows: $110, $115, $120, $125, $130, and $135. Because the option has a term of more than 90 days, the LQB is $125, the second highest strike price that is less than $130.25, the applicable stock price. The call option is a deep-in-the-money option because its strike price is lower than the LQB. Therefore, the option is not a qualified covered call option, and the loss deferral rules apply if you closed out the option or the stock at a loss during the year.

Capital loss on qualified covered call options. If you hold stock and you write a qualified covered call option on that stock with a strike price less than the applicable stock price, treat any loss from the option as long-term capital loss if, at the time the loss was realized, gain on the sale or exchange of the stock would be treated as long-term capital gain. The holding period of the stock does not include any period during which you are the writer of the option.

Special year-end rule. The loss deferral rules for straddles apply if all of the following are true.

1. The qualified covered call options are closed or the stock is disposed of at a loss during any tax year.
2. Gain on disposition of the stock or gain on the options is includible in gross income in a later tax year.
3. The stock or options were held less than 30 days after the closing of the options or the disposition of the stock.

How To Report Gains and Losses (Form 6781)

Report each position (whether or not it is part of a straddle) on which you have unrecognized gain at the end of the tax year and the amount of this unrecognized gain in Part III of Form 6781. Use Part II of Form 6781 to figure your gains and losses on straddles before entering these amounts on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return.

Coordination of Loss Deferral Rules and Wash Sale Rules

Rules similar to the wash sale rules apply to any disposition of a position or positions of a straddle. First apply Rule 1, explained next, then apply Rule 2. However, Rule 1 applies only if stocks or securities make up a position that is part of the straddle. If a position in the straddle does not include stock or securities, use Rule 2.

Rule 1. You cannot deduct a loss on the disposition of shares of stock or securities that make up the positions of a straddle if, within a period beginning 30 days before the date of that disposition and ending 30 days after that date, you acquired substantially identical stock or securities. Instead, the loss will be carried over to the following tax year, subject to any further application of Rule 1 in that year. This rule will also apply if you entered into a contract or option to acquire the stock or securities within the time period described above. See Loss carryover, later, for more information about how to treat the loss in the following tax year.

Dealers. If you are a dealer in stock or securities, this loss treatment will not apply to any losses you sustained in the ordinary course of your business.

Example. You are not a dealer in stock or securities. On December 2, 2001, you bought stock in XX Corporation (XX stock) and an offsetting put option. On December 13, 2001, there was $20 of unrealized gain in the put option and you sold the XX stock at a $20 loss. By December 16, 2001, the value of the put option had declined, eliminating all unrealized gain in the position. On December 16, 2001, you bought a second XX stock position that is substantially identical to the XX stock you sold on December 13, 2001. At the end of the year there is no unrecognized gain in the put option or in the XX stock. Under these circumstances, the $20 loss will be disallowed for 2001 under Rule 1 because, within a period beginning 30 days before December 13, 2001, and ending 30 days after that date, you bought stock substantially identical to the XX stock you sold.

Rule 2. You cannot deduct a loss on the disposition of less than all of the positions of a straddle (your loss position) to the extent that any unrecognized gain at the close of the tax year in one or more of the following positions is more than the amount of any loss disallowed under Rule 1:

1. Successor positions,
2. Offsetting positions to the loss position, or
3. Offsetting positions to any successor position.

Successor position. A successor position is a position that is or was at any time offsetting to a second position, if both of the following conditions are met.

1. The second position was offsetting to the loss position that was sold.
2. The successor position is entered into during a period beginning 30 days before, and ending 30 days after, the sale of the loss position.

Example 1. On November 1, 2001, you entered into offsetting long and short positions in non-section 1256 contracts. On November 12, 2001, you disposed of the long position at a $10 loss. On November 14, 2001, you entered into a new long position (successor position) that is offsetting to the retained short position, but that is not substantially identical to the long position disposed of on November 12, 2001. You held both positions through year end, at which time there was $10 of unrecognized gain in the successor long position and no unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for 2001 because there is $10 of unrecognized gain in the successor long position.

Example 2. The facts are the same as in Example 1, except that at year end you have $4 of unrecognized gain in the successor long position and $6 of unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for 2001 because there is a total of $10 of unrecognized gain in the successor long position and offsetting short position.

Example 3. The facts are the same as in Example 1, except that at year end you have $8 of unrecognized gain in the successor long position and $8 of unrecognized loss in the offsetting short position. Under these circumstances, $8 of the total $10 realized loss will be disallowed for 2001 because there is $8 of unrecognized gain in the successor long position.

Loss carryover. If you have a disallowed loss that resulted from applying Rule 1 and Rule 2, you must carry it over to the next tax year and apply Rule 1 and Rule 2 to that carryover loss. For example, a loss disallowed in 2000 under Rule 1 will not be allowed in 2001, unless the substantially identical stock or securities (which caused the loss to be disallowed in 2000) were disposed of during 2001. In addition, the carryover loss will not be allowed in 2001 if Rule 1 or Rule 2 disallows it.

Example. The facts are the same as in the example under Rule 1 above, except that on December 31, 2002, you sell the XX stock at a $20 loss and there is $40 of unrecognized gain in the put option. Under these circumstances, you cannot deduct in 2002 either the $20 loss disallowed in 2001 or the $20 loss you incurred for the December 31, 2002, sale of XX stock. Rule 1 does not apply because the substantially identical XX stock was sold during the year and no substantially identical stock or securities were bought within the 61-day period. However, Rule 2 does apply because there is $40 of unrecognized gain in the put option, an offsetting position to the loss positions.

Capital loss carryover. If the sale of a loss position would have resulted in a capital loss, you treat the carryover loss as a capital loss on the date it is allowed, even if you would treat the gain or loss on any successor positions as ordinary income or loss. Likewise, if the sale of a loss position (in the case of section 1256 contracts) would have resulted in a 60% long-term capital loss and a 40% short-term capital loss, you treat the carryover loss under the 60/40 rule, even if you would treat any gain or loss on any successor positions as 100% long-term or short-term capital gain or loss.

Exceptions. The rules for coordinating straddle losses and wash sales do not apply to the following loss situations.

1. Loss on the sale of one or more positions in a hedging transaction. (Hedging transactions are described under Section 1256 Contracts Marked to Market, earlier.)
2. Loss on the sale of a loss position in a mixed straddle account. (See the discussion later on the mixed straddle account election.)
3. Loss on the sale of a position that is part of a straddle consisting only of section 1256 contracts.

Holding Period and Loss Treatment Rules

The holding period of a position in a straddle generally begins no earlier than the date on which the straddle ends (the date you no longer hold an offsetting position). This rule does not apply to any position you held more than 1 year before you established the straddle. But see Exceptions, later.

Example. On March 6, 2000, you acquired gold. On January 4, 2001, you entered into an offsetting short gold forward contract (nonregulated futures contract). On April 1, 2001, you disposed of the short gold forward contract at no gain or loss. On April 8, 2001, you sold the gold at a gain. Because the gold had been held for 1 year or less before the offsetting short position was entered into, the holding period for the gold begins on April 1, 2001, the date the straddle ended. Gain recognized on the sale of the gold will be treated as short-term capital gain.

Loss treatment. Treat the loss on the sale of one or more positions (the loss position) of a straddle as a long-term capital loss if both of the following are true.

1. You held (directly or indirectly) one or more offsetting positions to the loss position on the date you entered into the loss position.
2. You would have treated all gain or loss on one or more of the straddle positions as long-term capital gain or loss if you had sold these positions on the day you entered into the loss position.

Mixed straddles. Special rules apply to a loss position that is part of a mixed straddle and that is a non-section 1256 position. A mixed straddle is a straddle:

1. That is not part of a larger straddle,
2. In which all positions are held as capital assets,
3. In which at least one (but not all) of the positions is a section 1256 contract, and
4. For which the mixed straddle election (Election A, discussed later) has not been made.

Treat the loss as 60% long-term capital loss and 40% short-term capital loss, if all of the following conditions apply.

1. Gain or loss from the sale of one or more of the straddle positions that are section 1256 contracts would be considered gain or loss from the sale or exchange of a capital asset.
2. The sale of no position in the straddle, other than a section 1256 contract, would result in a long-term capital gain or loss.
3. You have not made a straddle-by-straddle identification election (Election B) or mixed straddle account election (Election C), both discussed later.

Example. On March 1, 2001, you entered into a long gold forward contract. On July 15, 2001, you entered into an offsetting short gold regulated futures contract. You did not make an election to offset gains and losses from positions in a mixed straddle. On August 9, 2001, you disposed of the long forward contract at a loss. Because the gold forward contract was part of a mixed straddle and the disposition of this non-section 1256 position would not result in long-term capital loss, the loss recognized on the termination of the gold forward contract will be treated as a 60% long-term and 40% short-term capital loss.

Exceptions. The special holding period and loss treatment for straddle positions does not apply to positions that:

1. Constitute part of a hedging transaction,
2. Are included in a straddle consisting only of section 1256 contracts, or
3. Are included in a mixed straddle account (Election C), discussed later.

Mixed Straddles

If you disposed of a position in a mixed straddle and make one of the elections described in the following discussions, report your gain or loss as indicated in those discussions. If you do not make any of the elections, report your gain or loss in Part II of Form 6781. If you disposed of the section 1256 component of the straddle, enter the recognized loss (line 10, column (h)) or your gain (line 12, column (f)) in Part I of Form 6781, on line 1. Do not include it on line 11 or 13 (Part II).

Mixed straddle election (Election A). You can elect out of the marked to market rules, discussed under Section 1256 Contracts Marked to Market, earlier, for all section 1256 contracts that are part of a mixed straddle. Instead, the gain and loss rules for straddles will apply to these contracts. However, if you make this election for an option on a section 1256 contract, the gain or loss treatment discussed earlier under Options will apply, subject to the gain and loss rules for straddles.

You can make this election if:

1. At least one (but not all) of the positions is a section 1256 contract, and
2. Each position forming part of the straddle is clearly identified as being part of that straddle on the day the first section 1256 contract forming part of the straddle is acquired.

If you make this election, it will apply for all later years as well. It cannot be revoked without the consent of the IRS. If you made this election, check box A of Form 6781. Do not report the section 1256 component in Part I.

Other elections. You can avoid the 60% long-term capital loss treatment required for a non-section 1256 loss position that is part of a mixed straddle, described earlier, if you choose either of the two following elections to offset gains and losses for these positions.

1. Election B. Make a separate identification of the positions of each mixed straddle for which you are electing this treatment (the straddle-by-straddle identification method).
2. Election C. Establish a mixed straddle account for a class of activities for which gains and losses will be recognized and offset on a periodic basis.

These two elections are alternatives to the mixed straddle election. You can choose only one of the three elections. Use Form 6781 to indicate your election choice by checking box A, B, or C, whichever applies.

Straddle-by-straddle identification election (Election B). Under this election, you must clearly identify each position that is part of the identified mixed straddle by the earlier of:

1. The close of the day the identified mixed straddle is established, or
2. The time the position is disposed of.

If you dispose of a position in the mixed straddle before the end of the day on which the straddle is established, this identification must be made by the time you dispose of the position. You are presumed to have properly identified a mixed straddle if independent verification is used.

The basic tax treatment of gain or loss under this election depends on which side of the straddle produced the total net gain or loss. If the net gain or loss from the straddle is due to the section 1256 contracts, gain or loss is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. Enter the net gain or loss in Part I of Form 6781 and identify the election by checking box B.

If the net gain or loss is due to the non-section 1256 positions, gain or loss is short-term capital gain or loss. Enter the net gain or loss on Part I of Schedule D and identify the election.

For the specific application of the rules of this election, see regulations section 1.1092(b)-3T.

Example. On April 1, you entered into a non-section 1256 position and an offsetting section 1256 contract. You also made a valid election to treat this straddle as an identified mixed straddle. On April 8, you disposed of the non-section 1256 position at a $600 loss and the section 1256 contract at an $800 gain. Under these circumstances, the $600 loss on the non-section 1256 position will be offset against the $800 gain on the section 1256 contract. The net gain of $200 from the straddle will be treated as 60% long-term capital gain and 40% short-term capital gain because it is due to the section 1256 contract.

Mixed straddle account (Election C). You may elect to establish one or more accounts for determining gains and losses from all positions in a mixed straddle. You must establish a separate mixed straddle account for each separate designated class of activities.

Generally, you must determine gain or loss for each position in a mixed straddle account as of the close of each business day of the tax year. You offset the net section 1256 contracts against the net non-section 1256 positions to determine the "daily account net gain or loss."

If the daily account amount is due to non-section 1256 positions, the amount is treated as short-term capital gain or loss. If the daily account amount is due to section 1256 contracts, the amount is treated as 60% long-term and 40% short-term capital gain or loss.

On the last business day of the tax year, you determine the "annual account net gain or loss" for each account by netting the daily account amounts for that account for the tax year. The "total annual account net gain or loss" is determined by netting the annual account amounts for all mixed straddle accounts that you had established.

The net amounts keep their long-term or short-term classification. However, no more than 50% of the total annual account net gain for the tax year can be treated as long-term capital gain. Any remaining gain is treated as short-term capital gain. Also, no more than 40% of the total annual account net loss can be treated as short-term capital loss. Any remaining loss is treated as long-term capital loss.

The election to establish one or more mixed straddle accounts for each tax year must be made by the due date (without extensions) of your income tax return for the immediately preceding tax year. If you begin trading in a new class of activities during a tax year, you must make the election for the new class of activities by the later of either:

1. The due date of your return for the immediately preceding tax year (without extensions), or
2. 60 days after you entered into the first mixed straddle in the new class of activities.

You make the election on Form 6781 by checking box C. Attach Form 6781 to your income tax return for the immediately preceding tax year, or file it within 60 days, if that applies. Report the annual account net gain or loss from a mixed straddle account in Part II of Form 6781. In addition, you must attach a statement to Form 6781 specifically designating the class of activities for which a mixed straddle account is established.

For the specific application of the rules of this election, see regulations section 1.1092(b)-4T.

Interest expense and carrying charges relating to mixed straddle account positions. You cannot deduct interest and carrying charges that are allocable to any positions held in a mixed straddle account. Treat these charges as an adjustment to the annual account net gain or loss and allocate them proportionately between the net short-term and the net long-term capital gains or losses.

To find the amount of interest and carrying charges that is not deductible and that must be added to the annual account net gain or loss, apply the rules described in chapter 3 under Interest expense and carrying charges on straddles to the positions held in the mixed straddle account.

Sales of Stock to ESOPs or Certain Cooperatives

If you sold qualified securities held for at least 3 years to an employee stock ownership plan (ESOP) or eligible worker-owned cooperative, you may be able to elect to postpone all or part of the gain on the sale if you bought qualified replacement property (certain securities) within the period that began 3 months before the sale and ended 12 months after the sale. If you make the election, you must recognize gain on the sale only to the extent the proceeds from the sale exceed the cost of the qualified replacement property.

You must reduce the basis of the replacement property by any postponed gain. If you dispose of any replacement property, you may have to recognize all of the postponed gain.

Generally, to qualify for the election the ESOP or cooperative must own at least 30% of the outstanding stock of the corporation that issued the qualified securities. Also, the qualified replacement property must have been issued by a domestic operating corporation.

How to make the election. You must make the election no later than the due date (including extensions) for filing your tax return for the year in which you sold the stock. If your original return was filed on time, you may make the election on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Print "Filed pursuant to section 301.9100-2" at the top of the amended return, and file it at the same address you used for your original return.

How to report and postpone gain. Report the entire gain realized on line 8 of Schedule D. To make the choice to postpone gain, enter "Section 1042 election" in column (a) of the line directly below the line on which you reported the gain. Enter in column (f) the amount of the gain you are postponing or expecting to postpone. Enter it as a loss (in parentheses). If the actual postponed gain is different from the amount you report, file an amended return.

Also attach the following statements.

1. A "statement of election" that indicates you are making an election under section 1042(a) of the Internal Revenue Code and that includes the following information.
   1. A description of the securities sold, the date of the sale, the amount realized on the sale, and the adjusted basis of the securities.
   2. The name of the ESOP or cooperative to which the qualified securities were sold.
   3. For a sale that was part of a single, interrelated trasaction under a prearranged agreement between taxpayers involving other sales of qualified securities, the names and identifying numbers of the other taxpayers under the agreement and the number of shares sold by the other taxpayers.
2. A notarized "statement of purchase" describing the qualified replacement property, date of purchase, and the cost of the property and declaring the property to be qualified replacement property for the qualified stock you sold. The statement must have been notarized no later than 30 days after the purchase. If you have not yet purchased the qualified replacement property, you must attach the notarized "statement of purchase" to your income tax return for the year following the election year (or the election will not be valid).
3. A verified written statement of the domestic corporation whose employees are covered by the ESOP acquiring the securities, or of any authorized officer of the cooperative, consenting to the taxes under sections 4978 and 4979A of the Internal Revenue Code on certain dispositions, and prohibited allocations of the stock purchased by the ESOP or cooperative.

More information. For details, see section 1042 of the Internal Revenue Code and Temporary Regulations section 1.1042-1T.

Rollover of Gain From Publicly Traded Securities

You may qualify for a tax-free rollover of certain gains from the sale of publicly traded securities. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of your gain.

You postpone the gain by adjusting the basis of the replacement property as described in Basis of replacement property, later. This postpones your gain until the year you dispose of the replacement property.

You qualify to make this choice if you meet all the following tests.

1. You sell publicly traded securities at a gain. Publicly traded securities are securities traded on an established securities market.
2. Your gain from the sale is a capital gain.
3. During the 60-day period beginning on the date of the sale, you buy replacement property. This replacement property must be either common stock or a partnership interest in a specialized small business investment company (SSBIC). This is any partnership or corporation licensed by the Small Business Administration under section 301(d) of the Small Business Investment Act of 1958, as in effect on May 13, 1993.

Amount of gain recognized If you make the choice described in this section, you must recognize gain only up to the following amount:

1. The amount realized on the sale, minus
2. The cost of any common stock or partnership interest in an SSBIC that you bought during the 60-day period beginning on the date of sale (and did not previously take into account on an earlier sale of publicly traded securities).

If this amount is less than the amount of your gain, you can postpone the rest of your gain, subject to the limit described next. If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain.

Limit on gain postponed. The amount of gain you can postpone each year is limited to the smaller of:

1. $50,000 ($25,000 if you are married and file a separate return), or
2. $500,000 ($250,000 if you are married and file a separate return), minus the amount of gain you postponed for all earlier years.

Basis of replacement property. You must subtract the amount of postponed gain from the basis of your replacement property.

How to report and postpone gain. Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone gain, enter "SSBIC Rollover" in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

Also, attach a schedule showing how you figured the postponed gain, the name of the SSBIC in which you purchased common stock or a partnership interest, the date of that purchase, and your new basis in that SSBIC stock or partnership interest.

You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which you sold the securities. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Print "Filed pursuant to section 301.9100-2" at the top of the amended return, and file it at the same address you used for your original return.

Your choice is revocable with the consent of the IRS.

Gains on Qualified Small Business Stock

This section discusses two provisions of the law that may apply to gain from the sale or trade of qualified small business stock. You may qualify for a tax-free rollover of all or part of the gain. You may be able to exclude part of the gain from your income.

Qualified small business stock. This is stock that meets all the following tests.

1. It must be stock in a C corporation.
2. It must have been originally issued after August 10, 1993.
3. The corporation must have total gross assets of $50 million or less at all times after August 9, 1993, and before it was issued the stock. Its total gross assets immediately after it issued the stock must also be $50 million or less.

   When figuring the corporation's total gross assets, you must also count the assets of any predecessor of the corporation. In addition, you must treat all corporations that are members of the same parent-subsidiary controlled group as one corporation.

4. You must have acquired the stock at its original issue, directly or through an underwriter, in exchange for money or other property (not including stock), or as pay for services provided to the corporation (other than services performed as an underwriter of the stock). In certain cases, your stock may also meet this test if you acquired it from another person who met this test, or through a conversion or trade of qualified small business stock that you held.
5. The corporation must have met the active business test, defined next, and must have been a C corporation during substantially all the time you held the stock.
6. Within the period beginning 2 years before and ending 2 years after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from you or a related party.
7. Within the period beginning 1 year before and ending 1 year after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all its stock.

For more information about tests 6 and 7, see the regulations under section 1202 of the Internal Revenue Code.

Active business test. A corporation meets this test for any period of time if, during that period, both the following are true.

1. It was an eligible corporation, defined below.
2. It used at least 80% (by value) of its assets in the active conduct of at least one qualified trade or business, defined below.

Exception for SSBIC. Any specialized small business investment company (SSBIC) is treated as meeting the active business test. An SSBIC is an eligible corporation that is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 as in effect on May 13, 1993.

Eligible corporation. This is any U.S. corporation other than:

1. A Domestic International Sales Corporation (DISC) or a former DISC,
2. A corporation that has made, or whose subsidiary has made, an election under section 936 of the Internal Revenue Code, concerning the Puerto Rico and possession tax credit,
3. A regulated investment company,
4. A real estate investment trust (REIT),
5. A real estate mortgage investment conduit (REMIC),
6. A financial asset securitization investment trust (FASIT), or
7. A cooperative.

Qualified trade or business. This is any trade or business other than:

1. One involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services,
2. One whose principal asset is the reputation or skill of one or more employees,
3. Any banking, insurance, financing, leasing, investing, or similar business,
4. Any farming business (including the business of raising or harvesting trees),
5. Any business involving the production or extraction of products for which percentage depletion can be claimed, or
6. Any business of operating a hotel, motel, restaurant, or similar business.

Rollover of Gain

You may qualify for a tax-free rollover of capital gain from the sale of qualified small business stock held more than 6 months. This means that, if you buy certain replacement stock and make the choice described in this section, you postpone part or all of your gain.

You postpone the gain by adjusting the basis of the replacement stock as described in Basis of replacement stock, below. This postpones your gain until the year you dispose of the replacement stock.

You can make this choice if you meet all the following tests.

1. You buy replacement stock during the 60-day period beginning on the date of the sale.
2. The replacement stock is qualified small business stock.
3. The replacement stock continues to meet the active business requirement for small business stock for at least the first 6 months after you buy it.

Amount of gain recognized. If you make the choice described in this section, you must recognize the capital gain only up to the following amount:

1. The amount realized on the sale, minus
2. The cost of any qualified small business stock you bought during the 60-day period beginning on the date of sale (and did not previously take into account on an earlier sale of qualified small business stock).

If this amount is less than the amount of your capital gain, you can postpone the rest of that gain. If this amount equals or is more than the amount of your capital gain, you must recognize the full amount of your gain.

Basis of replacement stock. You must subtract the amount of postponed gain from the basis of your replacement stock.

Holding period of replacement stock. Your holding period for the replacement stock includes your holding period for the stock sold, except for the purpose of applying the 6-month holding period requirement for choosing to roll over the gain on its sale.

Pass-through entity. A pass-through entity (a partnership, S corporation, or mutual fund or other regulated investment company) also may make the choice to postpone gain. The benefit of the postponed gain applies to your share of the entity's postponed gain if you held an interest in the entity for the entire period the entity held the stock.

If a pass-through entity sold qualified small business stock held for more than 6 months and you held an interest in the entity for the entire period the entity held the stock, you also may choose to postpone gain if you, rather than the pass-through entity, buy the replacement stock within the 60-day period.

How to report gain. Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone the gain, enter "Section 1045 Rollover" in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which the stock was sold. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Print "Filed pursuant to section 301.9100-2" at the top of the amended return, and file it at the same address you used for your original return.

Section 1202 Exclusion

You generally can exclude from your income one-half of your gain from the sale or trade of qualified small business stock held by you for more than 5 years. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Capital Gain Tax Rates, later.

SSBIC stock. If the stock is specialized small business investment company (SSBIC) stock that you bought as replacement property for publicly traded securities you sold at a gain, you must reduce the basis of the stock by the amount of any postponed gain on that earlier sale, as explained earlier under Rollover of Gain From Publicly Traded Securities. But do not reduce your basis by that amount when figuring your section 1202 exclusion.

Limit on eligible gain. The amount of your gain from the stock of any one issuer that is eligible for the exclusion in 2001 is limited to the greater of:

1. Ten times your basis in all qualified stock of the issuer that you sold or exchanged during the year, or
2. $10 million ($5 million for married individuals filing separately) minus the amount of gain from the stock of the same issuer that you used to figure your exclusion in earlier years.

How to report gain. Report the entire gain realized from the sale in column (f) of line 8 of Schedule D (Form 1040). Report an amount equal to the excluded gain in column (g). Directly below the line on which you report the gain, enter "Section 1202 exclusion" in column (a) and enter the amount of the exclusion in column (f). Enter it as a loss (in parentheses).

More information. For information about additional requirements that may apply, see section 1202 of the Internal Revenue Code.

Rollover of Gain From Sale of Empowerment Zone Assets

You may qualify for a tax-free rollover of certain gains from the sale of qualified empowerment zone assets. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of the recognition of your gain.

You qualify to make this choice if you meet all the following tests.

1. You hold a qualified empowerment zone asset for more than 1 year and sell it at a gain.
2. Your gain from the sale is a capital gain.
3. During the 60-day period beginning on the date of the sale, you buy a replacement qualified empowerment zone asset in the same zone as the asset sold.

Qualified empowerment zone asset. This means certain stock or partnership interests in an enterprise zone business. It also includes certain tangible property used in an enterprise zone business. You must have acquired the asset after December 21, 2000.

Amount of gain recognized. If you make the choice described in this section, you must recognize gain only up to the following amount:

1. The amount realized on the sale, minus
2. The cost of any qualified empowerment zone asset that you bought during the 60-day period beginning on the date of sale (and did not previously take into account in rolling over gain on an earlier sale of qualified empowerment zone assets).

If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain. If this amount is less than the amount of your gain, you can postpone the rest of your gain by adjusting the basis of your replacement property as described next.

Basis of replacement property. You must subtract the amount of postponed gain from the basis of the qualified empowerment zone assets you bought as replacement property.

How to report and postpone gain. Report the entire gain realized from the sale on line 8 of Schedule D (Form 1040). To make the choice to postpone gain, enter "Section 1397B Rollover" in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

Also attach a statement describing:

1. How you figured the postponed gain,
2. The name of the empowerment zone(s) in which the property sold and purchased is located,
3. The qualified empowerment zone asset(s) purchased, including the date of purchase, and
4. Your adjusted basis in the asset(s).

More information. For more information about empowerment zones, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities. For more information about this rollover of gain, see section 1397B of the Internal Revenue Code.

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