The 21st Century Solutions to Hedging Low-Basis Stock

Abstract

Confusion among practitioners on just what can and can’t be done to hedge and monetize a low-cost-basis stock without triggering a taxable sale is widespread. Investors can still hedge and monetize without concern for triggering a sale, although the task is more difficult than it needs to be. Hedging was fairly straightforward until 1997 when the constructive sale rules (IRC Section 1259) were enacted. The constructive sale rules force owners of low-basis shares to retain some upside or downside when hedging. Before these rules a perfect hedge was permissible, before 1997 we recommended a short-against-the-box, others advocated equity swaps, and others, deep-in-the money calls (all would now trigger a gain under IRC Section 1259). Although it seems daunting, hedging and monetization can still be safely executed without negative tax concerns if investors are careful to avoid the traps that are possible in such an endeavor. <b>TOPICS:</b>Security analysis and valuation, derivatives, legal/regulatory/public policy