Capital Gains and 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 fromdifferent types of investment transactions. Character of gain or loss.You need to classify your gains and losses as either ordinary orcapital gains or losses. You then need to classify your capital gainsand losses as either short term or long term. If you have long-termgains and losses, you must identify your 28% rate gains and losses. Ifyou have a net capital gain, you must also identify any unrecapturedsection 1250 gain. The correct classification and identification helps you figure thelimit on capital losses and the correct tax on capital gains. Forinformation about determining whether your capital gain or loss isshort term or long term, see Holding Period, later. Forinformation about whether your long-term gain or loss is a 28% rategain or loss and about unrecaptured section 1250 gain, seeReporting Capital Gains and Losses and Capital GainsTax Rates, later. Capital or OrdinaryGain 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 acapital asset (defined next) results in a capital gain or loss. A saleor trade of a noncapital asset generally results in ordinary gain orloss. Depending on the circumstances, a gain or loss on a sale ortrade of property used in a trade or business may be treated as eithercapital or ordinary, as explained in Publication 544. In somesituations, part of your gain or loss may be a capital gain or loss,and part may be an ordinary gain or loss. Capital Assets andNoncapital Assets For the most part, everything you own and use for personalpurposes, pleasure, or investment is a capital asset. Someexamples 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 followingnoncapital assets. Property held mainly for sale to customers orproperty that will physically become a part of the merchandise that isfor sale to customers. Depreciable property used in your trade orbusiness, even if fully depreciated. Real property used in your trade orbusiness. A copyright, a literary, musical, or artisticcomposition, a letter or memorandum, or similar property -- Created by your personal efforts, Prepared or produced for you (in the case of a letter,memorandum, or similar property), or Acquired under circumstances (for example, by gift)entitling you to the basis of the person who created the property orfor whom it was prepared or produced. Accounts or notes receivable acquired in theordinary course of a trade or business for services rendered or fromthe sale of any of the properties described in (1). U.S. Government publications that you receivedfrom the government free or for less than the normal sales price, orthat you acquired under circumstances entitling you to the basis ofsomeone who received the publications free or for less than the normalsales price. Certain commodities derivative financial instrumentsheld, acquired, or entered into by commodities derivativesdealers after December 16, 1999. For more information, see section1221 of the Internal Revenue Code. Hedging transactions entered into after December16, 1999, but only if the transaction is clearly identified as ahedging transaction before the close of the day on which it wasacquired, originated, or entered into. For more information, see thedefinition of "hedging transaction" earlier, and the discussionof hedging transactions under Commodity Futures,later. Supplies of a type you regularly use or consumein the ordinary course of your trade or business, that you held oracquired after December 16, 1999. Investment property.Investment property is a capital asset. Any gain or loss from itssale 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 adealer. Any gain or loss from their sale or trade generally is acapital gain or loss. Stocks, stock rights, and bonds.All of these, including stock received as a dividend, are capitalassets except when they are held for sale by a securities dealer.However, see Losses on Section 1244 (Small Business) Stockand Losses on Small Business Investment Company Stock,later. Personal use property.Property held for personal use only, rather than for investment, isa capital asset, and you must report a gain from its sale as a capitalgain. However, you cannot deduct a loss from selling personal useproperty. Discounted Debt Instruments Treat your gain or loss on the sale, redemption, or retirement of abond or other debt instrument originally issued at a discount orbought at a discount as capital gain or loss, except as explained inthe following discussions. Short-term government obligations.Treat gains on short-term federal, state, or local governmentobligations (other than tax-exempt obligations) as ordinary income upto your ratable share of the acquisition discount. This treatmentapplies to obligations that have a fixed maturity date not more than 1year from the date of issue. Acquisition discount is thestated redemption price at maturity minus your basis in theobligation. However, do not treat these gains as income to the extent youpreviously included the discount in income. See Discount onShort-Term Obligations in chapter 1for more information. Short-term nongovernment obligations.Treat gains on short-term nongovernment obligations as ordinaryincome up to your ratable share of OID. This treatment applies toobligations that have a fixed maturity date of not more than 1 yearfrom the date of issue. However, to the extent you previously included the discount inincome, you do not have to include it in income again. SeeDiscount on Short-Term Obligations, in chapter 1,for moreinformation. Tax-exempt state and local government bonds.If these bonds were originally issued at a discount beforeSeptember 4, 1982, or you acquired them before March 2, 1984, treatyour part of the OID as tax-exempt interest. To figure your gain orloss on the sale or trade of these bonds, reduce the amount realizedby your part of the OID. If the bonds were issued after September 3, 1982, and acquiredafter March 1, 1984, increase the adjusted basis by your part of theOID to figure gain or loss. For more information on the basis of thesebonds, see Discounted tax-exempt obligations underStocks and Bonds, earlier in this chapter. Any gain from market discount is usually taxable on disposition orredemption of tax-exempt bonds. If you bought the bonds before May 1,1993, the gain from market discount is capital gain. If you bought thebonds after April 30, 1993, the gain from market discount is ordinaryincome. You figure market discount by subtracting the price you paid forthe bond from the sum of the original issue price of the bond and theamount of accumulated OID from the date of issue that representedinterest to any earlier holders. For more information, see MarketDiscount Bonds in chapter 1. A loss on the sale or other disposition of a tax-exempt state orlocal 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 toyou. If a state or local bond issued after June 8, 1980, isredeemed before it matures, the part of the OID that is earned whileyou hold the bond is not taxable to you. However, you must report theunearned part of the OID as a capital gain. Example.On July 1, 1989, 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 hadno intention of redeeming it before it matured. The bond was callableat its face amount beginning 10 years after the issue date. The issuer redeemed the bond at the end of 11 years (July 1, 2000)for its face amount of $1,000 plus accrued annual interest of $60. TheOID earned during the time you held the bond, $73, is not taxable. The$60 accrued annual interest also is not taxable. However, you mustreport the unearned part of the OID ($127) as a capital gain. Long-term debt instruments issued after 1954 and before May28, 1969 (or before July 2, 1982, if a government instrument).If you sell, trade, or redeem for a gain one of these debtinstruments, the part of your gain that is not more than your ratableshare 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 anintention to call the debt instrument before maturity, all of yourgain that is not more than the entire OID is treated as ordinaryincome at the time of the sale. This treatment of taxable gain alsoapplies to corporate instruments issued after May 27, 1969, under awritten commitment that was binding on May 27, 1969, and at all timesthereafter. Example 1.You bought a 30-year, 6% government bond for $700 at original issueon April 1, 1982, and sold it for $800 on April 20, 2000. Theredemption price is $1,000. At the time of original issue, there wasno intention to call the bond before maturity. You have held the bondfor 216 full months. Do not count the additional days that are lessthan a full month. The number of complete months from date of issue todate of maturity is 360 (30 years). The fraction 216/360 multiplied bythe discount of $300 ($1,000 - $700) is equal to $180. This isyour ratable share of OID for the period you owned the bond. You musttreat any part of the gain up to $180 as ordinary income. As a result,your $100 gain is treated as ordinary income. Example 2.If, in Example 1, you sold the bond for $900, you wouldhave a gain of $200. Of that amount, $180 is ordinary income and $20is long-term capital gain. Long-term debt instruments issued after May 27, 1969 (orafter July 1, 1982, if a government instrument).If you hold one of these debt instruments, you must include a partof 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 OIDthat you have included in your gross income. See Original IssueDiscount (OID) in chapter 1. If you sell or trade the debt instrument before maturity, your gainis a capital gain. However, if at the time the instrument wasoriginally issued there was an intention to call it before itsmaturity, your gain generally is ordinary income to the extent of theentire OID reduced by any amounts of OID previously includible in yourincome. In this case, the rest of the gain is a capital gain. An intention to call a debt instrument before maturity means thereis a written or oral agreement or understanding not provided for inthe debt instrument between the issuer and original holder that theissuer will redeem the debt instrument before maturity. In the case ofdebt instruments that are part of an issue, the agreement orunderstanding must be between the issuer and the original holders of asubstantial amount of the debt instruments in the issue. Example 1.On February 4, 1998, you bought at original issue for $7,600, JonesCorporation's 10-year, 5% bond which has a stated redemption price atmaturity of $10,000. On February 3, 2000, you sold the bond to SusanGreen for $9,040. Assume you have included $334 of the OID in yourgross income and increased your basis in the bond by that amount. Thisincludes the amount accrued for 2000. Your basis is now $7,934. If atthe time of the original issue there was no intention to call the bondbefore maturity, your gain of $1,106 ($9,040 amount realized minus$7,934 adjusted basis) is a long-term capital gain. Example 2.If, in Example 1, at the time of original issue therewas an intention to call the bond before maturity, your entire gain isordinary income. You figure this as follows: 1) Entire OID ($10,000 stated redemption price atmaturity minus $7,600 issue price) $2,400 2) Minus: Amount previously includedin income        334 3) Maximum amount of ordinary income     $2,066 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 includethe discount in income as it accrued, increase your basis in the debtinstrument by the accrued discount to figure capital gain or loss onits disposition. If you did not choose to include the discount inincome as it accrued, you must report gain as ordinary interest incomeup to the instrument's accrued market discount. See MarketDiscount Bonds in chapter 1.The rest of the gain is capitalgain. However, a different rule applies if you dispose of a marketdiscount bond that was: Issued before July 19, 1984, and Purchased by you before May 1, 1993. In that case, any gain is treated as interest income up to theamount of your deferred interest deduction for the year you dispose ofthe bond. The rest of the gain is capital gain. (Deferred interestdeduction for market discount bonds is discussed in chapter 3underWhen 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 gainand 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) asinterest 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 instrumentis treated in the same way as if you had sold or traded thatinstrument. Notes of individuals.If you hold an obligation of an individual that was issued with OIDafter March 1, 1984, you generally must include the OID in your incomecurrently, and your gain or loss on its sale or retirement isgenerally capital gain or loss. An exception to this treatment appliesif the obligation is a loan between individuals and all of thefollowing requirements are met. The lender is not in the business of lending money. The amount of the loan, plus the amount of any outstandingprior loans, is $10,000 or less. Avoiding federal tax is not one of the principal purposes ofthe loan. If the exception applies, or the obligation was issued before March2, 1984, you do not include the OID in your income currently. When yousell or redeem the obligation, the part of your gain that is not morethan 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 orredemption is capital loss. Bearer Obligations You cannot deduct any loss on an obligation required to be inregistered form that is instead held in bearer form. In addition, anygain on the sale or other disposition of the obligation is ordinaryincome. However, if the issuer was subject to a tax when theobligation was issued, then you can deduct any loss, and any gain mayqualify for capital gain treatment. Obligations required to be in registered form.Any obligation must be in registered form unless: It is issued by a natural person, It is not of a type offered to the public, It has a maturity at the date of issue of not more than 1year, or It was issued before 1983. Deposit in Insolvent orBankrupt Financial Institution If you lose money you have on deposit in a qualified financialinstitution that becomes insolvent or bankrupt, you may be able todeduct your loss in one of three ways. Ordinary loss, Casualty loss, or Nonbusiness bad debt (short-term capital loss). Ordinary loss or casualty loss. If you can reasonably estimate your loss, you can choose to treatthe estimated loss as either an ordinary loss or a casualty loss inthe current year. Either way, you claim the loss as an itemizeddeduction. If you claim an ordinary loss, report it as a miscellaneousitemized deduction on line 22 of Schedule A (Form 1040). The maximumamount you can claim is $20,000 ($10,000 if you are married filingseparately) reduced by any expected state insurance proceeds. Yourloss is subject to the 2%-of-adjusted-gross- income limit. You cannotchoose to claim an ordinary loss if any part of the deposit isfederally insured. If you claim a casualty loss, attach Form 4684,Casualties and Thefts, to your return. Each loss mustbe reduced by $100. Your total casualty losses for the year arereduced by 10% of your adjusted gross income. You cannot choose either of these methods if: You own at least 1% of the financial institution, You are an officer of the institution, or You are related to such an owner or officer. You are relatedif you and the owner or officer are "related parties," as definedearlier under Related Party Transactions, or if you are theaunt, uncle, nephew, or niece of the owner or officer. If the actual loss that is finally determined is more than theamount you deducted as an estimated loss, you can claim the excessloss as a bad debt. If the actual loss is less than the amountdeducted as an estimated loss, you must include in income (in thefinal determination year) the excess loss claimed. SeeRecoveries, in Publication 525, Taxable and NontaxableIncome. Nonbusiness bad debt. If you do not choose to deduct your estimated loss as a casualtyloss or an ordinary loss, you wait until the year the amount of theactual loss is determined and deduct it as a nonbusiness bad debt inthat year. Report it as a short-term capital loss on Schedule D (Form1040), as explained under Nonbusiness Bad Debts, later. Sale of Annuity The part of any gain on the sale of an annuity contract before itsmaturity date that is based on interest accumulated on the contract isordinary income. Conversion Transactions Generally, all or part of a gain on a conversion transaction istreated as ordinary income. This applies to gain on the disposition orother termination of any position you held as part of a conversiontransaction that you entered into after April 30, 1993. A conversion transaction is any transaction that meets both ofthese tests. Substantially all of your expected return from thetransaction is due to the time value of your net investment. In otherwords, the return on your investment is, in substance, like intereston a loan. The transaction is one of the following. A straddle as defined under Straddles, later, butincluding any set of offsetting positions on stock. Any transaction in which you acquire property (whether ornot actively traded) at substantially the same time that you contractto sell the same property, or substantially identical property, at aprice set in the contract. Any other transaction that is marketed or sold as producingcapital gains from a transaction described in (1). Amount treated as ordinary income.The amount of gain treated as ordinary income is the smaller of: The gain recognized on the disposition or other terminationof the position, or The "applicable imputed income amount." Applicable imputed income amount.Figure this amount as follows. Figure the amount of interest that would have accrued onyour net investment in the conversion transaction for the periodending on the earlier of: The date when you dispose of the position, or The date when the transaction stops being a conversiontransaction. To figure this amount, use an interest rate equal to 120% of the"applicable rate," defined later. Subtract from (1) the amount treated as ordinary income fromany earlier disposition or other termination of a position held aspart of the same conversion transaction. Applicable rate.If the term of the conversion transaction is indefinite, theapplicable rate is the federal short-term rate in effect under section6621(b) of the Internal Revenue Code during the period of theconversion transaction, compounded daily. In all other cases, the applicable rate is the "applicablefederal rate" determined as if the conversion transaction were adebt instrument and compounded semi-annually. The rates discussed above are published by the IRS in theInternal Revenue Bulletin. Or, you can contact the IRS toget these rates. See chapter 5for the number to call. Net investment.To determine your net investment in a conversion transaction,include the fair market value of any position at the time it becomespart of the transaction. This means that your net investment generallywill be the total amount you invested, less any amount you receivedfor entering into the position (for example, a premium you receivedfor writing a call). Position with built-in loss.A special rule applies when a position with a built-in loss becomespart of a conversion transaction. A built-in loss is any loss that youwould have realized if you had disposed of or otherwise terminated theposition at its fair market value at the time it became part of theconversion transaction. When applying the conversion transaction rules to a position with abuilt-in loss, use the position's fair market value at the time itbecame part of the transaction. But, when you dispose of or otherwiseterminate the position in a transaction in which you recognize gain orloss, you must recognize the built-in loss. The conversion transactionrules do not affect whether the built-in loss is treated as anordinary 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 sameconversion transaction. To do this, you have to dispose of all thepositions within a 14-day period that is within a single tax year. Youcannot net the built-in loss against the gain. Files: You can net gains and losses only if you identify the conversiontransaction as an identified netting transaction on your books andrecords. Each position of the conversion transaction must beidentified before the end of the day on which the position becomespart of the conversion transaction. For conversion transactionsentered into before February 20, 1996, this requirement is met if theidentification was made by that date. Options dealers and commodities traders.Special rules apply to options dealers and commodities traders. Seesection 1258(d)(5) of the Internal Revenue Code. How to report.Use Form 6781, Gains and Losses From Section 1256 Contractsand Straddles, to report conversion transactions. See theinstructions for lines 11 and 13 of Form 6781. Commodity Futures A commodity futures contract is a standardized, exchange-tradedcontract for the sale or purchase of a fixed amount of a commodity ata future date for a fixed price. If the contract is a regulated futures contract, the rulesdescribed earlier under Section 1256 Contracts Marked To Market,apply to it. The termination of a commodity futures contract generally resultsin capital gain or loss unless the contract is a hedging transaction. Hedging transaction.A futures contract that is a hedging transaction generallyproduces ordinary gain or loss. A futures contract is a hedgingtransaction if you enter into the contract in the ordinary course ofyour business primarily to manage the risk of interest rate or pricechanges or currency fluctuations on borrowings, ordinary property, orordinary obligations. (Generally, ordinary property or obligations arethose that cannot produce capital gain or loss under anycircumstances.) For example, the offset or exercise of a futurescontract that protects against price changes in your businessinventory results in an ordinary gain or loss. For more information about hedging transactions, see section1.1221-2 of the regulations. Also, see HedgingTransactions under Section 1256 Contracts Marked toMarket, earlier. Files: If you have numerous transactions in the commodity futures marketduring the year, the burden of proof is on you to show whichtransactions are hedging transactions. Clearly identify any hedgingtransactions on your books and records before the end of the day youentered into the transaction. It may be helpful to have separatebrokerage accounts for your hedging and nonhedging transactions. Forspecific requirements concerning identification of hedgingtransactions and the underlying item, items, or aggregate risk that isbeing 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 transactionentered into after July 11, 1999, involving a financial asset(discussed later) and the gain normally would be treated as long-termcapital gain, all or part of the gain may be treated instead asordinary income. In addition, if any gain is treated as ordinaryincome, your tax is increased by an interest charge. Constructive ownership transactions.The following are constructive ownership transactions. A notional principal contract (discussed below) in which youhave the right to receive substantially all of the investment yield ona financial asset and you are obligated to reimburse substantially allof any decline in value of the financial asset. A forward or futures contract to acquire a financialasset. The holding of a call option and writing of a put option ona financial asset at substantially the same strike price and maturitydate. This provision does not apply if all the positions are marked tomarket. Marked to market rules for section 1256 contracts arediscussed in detail under Section 1256 Contracts Marked toMarket, earlier. Financial asset.A financial asset, for this purpose, is any equity interest in apass-through entity. Pass-through entities include partnerships, Scorporations, trusts, regulated investment companies, and real estateinvestment trusts. Amount of ordinary income.Long-term capital gain is treated as ordinary income to the extentit is more than the net underlying long-term capital gain.The net underlying long-term capital gain is the amount of netcapital gain you would have realized if you acquired the asset for itsfair market value on the date the constructive ownership transactionwas opened, and sold the asset for its fair market value on the datethe transaction was closed. If you do not establish the amount of netunderlying long-term capital gain by clear and convincing evidence, itis treated as zero. More information.For more information, see section 1260 of the Internal RevenueCode. 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 BusinessProperty, line 10. Any gain on section 1244 stock is a capital gain if the stock is acapital asset in your hands. Do not offset gains against losses thatare within the ordinary loss limit, explained later in thisdiscussion, 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 thesale 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 ifonly one spouse has this type of loss. If your loss is $110,000 andyour spouse has no loss, you can deduct $100,000 as an ordinary losson 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 thanstock and securities) in a domestic small business corporation. Duringits 5 most recent tax years before the loss, this corporation musthave derived more than 50% of its gross receipts from other thanroyalties, rents, dividends, interest, annuities, and gains from salesand trades of stocks or securities. If the corporation was inexistence for at least 1 year, but less than 5 years, the 50% testapplies to the tax years ending before the loss. If the corporationwas in existence less than 1 year, the 50% test applies to the entireperiod the corporation was in existence before the day of the loss.However, if the corporation's deductions (other than the net operatingloss and dividends received deductions) were more than its grossincome during this period, this 50% test does not apply. The corporation must have been largely an operating company forordinary loss treatment to apply. If the stock was issued before July 19, 1984, the stock must becommon stock. If issued after July 18, 1984, the stock may be eithercommon or preferred. For more information about the requirements of asmall business corporation or the qualifications of section 1244stock, see section 1244 of the Internal Revenue Code and itsregulations. The stock must be issued to the person taking the loss.You must be the original owner of the stock to be allowed ordinaryloss treatment. To claim a deductible loss on stock issued to yourpartnership, you must have been a partner when the stock was issuedand have remained so until the time of the loss. You add yourdistributive share of the partnership loss to any individual section1244 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 treatany later loss on that stock as an ordinary loss. Stock sold through underwriter.Stock sold through an underwriter is not section 1244 stock unlessthe underwriter only acted as a selling agent for the corporation. Stock dividends and reorganizations.Stock you receive as a stock dividend qualifies as section 1244stock if: You receive it from a small business corporation in whichyou own stock, and The stock you own meets the requirements when the stockdividend is distributed. If you trade your section 1244 stock for new stock in the samecorporation in a reorganization that qualifies as a recapitalizationor 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 therequirements when the trade occurs. If you hold section 1244 stock and other stock in the samecorporation, not all of the stock you receive as a stock dividend orin a reorganization will qualify as section 1244 stock. Only that partbased on the section 1244 stock you hold will qualify. Example.Your basis for 100 shares of X common stock is $1,000. These sharesqualify as section 1244 stock. If, as a nontaxable stock dividend, youreceive 50 more shares of common stock, the basis of which isdetermined from the 100 shares you own, the 50 shares are also section1244 stock. If you also own stock in the corporation that is not section 1244stock when you receive the stock dividend, you must divide the sharesyou receive as a dividend between the section 1244 stock and the otherstock. Only the shares from the former can be section 1244 stock. Contributed property.To determine ordinary loss on section 1244 stock you receive in atrade for property, you have to reduce the basis of the stock if: The adjusted basis (for figuring loss) of the property,immediately before the trade, was more than its fair market value, and The basis of the stock is determined by the basis of theproperty. Reduce the basis of the stock by the difference between theadjusted basis of the property and its fair market value at the timeof 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 fairmarket value of $250 to a corporation for its section 1244 stock. Thebasis of your stock is $1,000, but to figure the ordinary loss underthese rules, the basis of your stock is $250 ($1,000 minus $750). Ifyou later sell the section 1244 stock for $200, your $800 loss is anordinary loss of $50 and a capital loss of $750. Contributions to capital.If the basis of your section 1244 stock has increased, throughcontributions to capital or otherwise, you must treat this increase asapplying to stock that is not section 1244 stock when you figure anordinary loss on its sale. Example.You buy 100 shares of section 1244 stock for $10,000. You are theoriginal owner. You later make a $2,000 contribution to capital thatincreases the total basis of the 100 shares to $12,000. You then sellthe 100 shares for $9,000 and have a loss of $3,000. You can deductonly $2,500 ($3,000 $10,000/$12,000) as an ordinary loss underthese rules. The remaining $500 is a capital loss. Files: Recordkeeping.You must keep recordssufficient to show your stock qualifies as section 1244 stock. Yourrecords must also distinguish your section 1244 stock from any otherstock you own in the corporation. Losses on Small Business Investment Company Stock A small business investment company (SBIC) is one that is licensedand operated under the Small Business Investment Act of 1958. If you are an investor in SBIC stock, you can deduct as an ordinaryloss, rather than a capital loss, a loss from the sale, trade, orworthlessness of that stock. A gain from the sale or trade of thatstock is a capital gain. Do not offset your gains and losses, even ifthey are on stock of the same company. How to report.You report this type of ordinary loss on line 10, Part II, of Form4797. In addition to the information required by the form, you mustinclude the name and address of the company that issued the stock.Report a capital gain from the sale of SBIC stock on Schedule D ofForm 1040. Short sale.If you close a short sale of SBIC stockwith other SBIC stock that youbought only for that purpose, any loss you have on the sale is acapital loss. See Short Sales, later in this chapter, formore information. Holding Period If you sold or traded investment property, you must determine yourholding period for the property. Your holding period determineswhether any capital gain or loss was a short-term or a long-termcapital gain or loss. Long-term or short-term.If you hold investment property more than 1 year, anycapital gain or loss is a long-term capital gain or loss.If you hold the property 1 year or less, any capital gainor loss is a short-term capital gain or loss. To determine how long you held the investment property, begincounting on the date after the day you acquired the property. The dayyou disposed of the property is part of your holding period. Example.If you bought investment property on February 5, 1999, and sold iton February 5, 2000, your holding period is not more than 1 year andyou have a short-term capital gain or loss. If you sold it on February6, 2000, your holding period is more than 1 year and you have along-term capital gain or loss. Securities traded on an established market.For securities traded on an established securities market, yourholding period begins the day after the trade date youbought the securities, and ends on the trade date you sold them. Caution: Do not confuse the trade date with the settlement date, which isthe date by which the stock must be delivered and payment must bemade. Example.You are a cash method, calendar year taxpayer. You sold stock at again on December 29, 2000. According to the rules of the stockexchange, the sale was closed by delivery of the stock 3 trading daysafter the sale, on January 4, 2001. You received payment of the saleprice on that same day. Report your gain on your 2000 return, eventhough you received the payment in 2001. The gain is long term orshort term depending on whether you held the stock more than 1 year.Your holding period ended on December 29. If you had sold the stock ata loss, you would also report it on your 2000 return. U.S. Treasury notes and bonds.The holding period of U.S. Treasury notes and bonds sold at auctionon the basis of yield starts the day after the Secretary of theTreasury, through news releases, gives notification of acceptance tosuccessful bidders. The holding period of U.S. Treasury notes andbonds sold through an offering on a subscription basis at a specifiedyield starts the day after the subscription is submitted. Automatic investment service.In determining your holding period for shares bought by the bank orother agent, full shares are considered bought first and anyfractional shares are considered bought last. Your holding periodstarts on the day after the bank's purchase date. If a share wasbought over more than one purchase date, your holding period for thatshare is a split holding period. A part of the share is considered tohave been bought on each date that stock was bought by the bank withthe proceeds of available funds. Nontaxable trades.If you acquire investment property in a trade for other investmentproperty and your basis for the new property is determined, in wholeor in part, by your basis in the old property, your holding period forthe new property begins on the day following the date you acquired theold property. Property received as a gift.If you receive a gift of property and your basis is determined bythe donor's adjusted basis, your holding period is considered to havestarted on the same day the donor's holding period started. If your basis is determined by the fair market value of theproperty, your holding period starts on the day after the date of thegift. Inherited property.If you inherit investment property, your capital gain or loss onany later disposition of that property is treated as a long-termcapital gain or loss. This is true regardless of how long you actuallyheld the property. Real property bought.To figure how long you have held real property bought under anunconditional contract, begin counting on the day after you receivedtitle to it or on the day after you took possession of it and assumedthe burdens and privileges of ownership, whichever happened first.However, taking delivery or possession of real property under anoption agreement is not enough to start the holding period. Theholding 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, andthen later repossess the property under the terms of the salescontract, your holding period for a later sale includes the period youheld the property before the original sale and the period after therepossession. Your holding period does not include the time betweenthe original sale and the repossession. That is, it does not includethe period during which the first buyer held the property. Stock dividends. The holding period for stock you received as a taxable stockdividend begins on the date of distribution. The holding period for new stock you received as a nontaxable stockdividend begins on the same day as the holding period of the oldstock. This rule also applies to stock acquired in a spin-off,which is a distribution of stock or securities in a controlledcorporation. Nontaxable stock rights.Your holding period for nontaxable stock rights begins on the sameday as the holding period of the underlying stock. The holding periodfor stock acquired through the exercise of stock rights begins on thedate the right was exercised. Section 1256 contracts.Gains or losses on section 1256 contracts open at the end of theyear, or terminated during the year, are treated as 60% long term and40% short term, regardless of how long the contracts were held. SeeSection 1256 Contracts Marked to Market, earlier. Option property.Your holding period for property you acquire when you exercise anoption begins the day after you exercise the option. Wash sales. Your holding period for substantially identical stock or securitiesyou acquire in a wash sale includes the period you held the old stockor securities. Qualified small business stock.Your holding period for stock you acquired in a tax-free rolloverof gain from a sale of qualified small business stock, describedlater, includes the period you held the old stock. Commodity futures.Futures transactions in any commodity subject to the rules of aboard of trade or commodity exchange are long term if the contract washeld for more than 6 months. Your holding period for a commodity received in satisfaction of acommodity futures contract, other than a regulated futures contractsubject to Internal Revenue Code section 1256, includes your holdingperiod for the futures contract if you held the contract as a capitalasset. 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 estateinvestment trust (REIT) for 6 months or less and then sell it ata loss (other than under a periodic liquidation plan), special rulesmay apply. Capital gain distributions received.The loss (after reduction for any exempt-interest dividends youreceived, as explained next) is treated as a long-term capital loss upto the total of any capital gain distributions you received and yourshare of any undistributed capital gains. Any remaining loss isshort-term capital loss. Exempt-interest dividends on mutual fund stock.If you received exempt-interest dividends on the stock, at leastpart of your loss is disallowed. You can deduct only the amount ofloss that is more than the exempt-interest dividends. Nonbusiness Bad Debts If someone owes you money that you cannot collect, you have a baddebt. You may be able to deduct the amount owed to you when you figureyour 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 yourtrade or business and is deductible as a business loss. All other baddebts are nonbusiness bad debts and are deductible as short-termcapital losses. Example.An architect made personal loans to several friends who were notclients. She could not collect on some of these loans. They aredeductible only as nonbusiness bad debts because the architect was notin the business of lending money and the loans do not have anyrelationship to her business. Business bad debts.For information on business bad debts of an employee, seePublication 529. For information on other business bad debts, seechapter 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 genuineif it arises from a debtor-creditor relationship based on a valid andenforceable 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 thetime of the transaction to make a loan and not a gift. If you lendmoney to a relative or friend with the understanding that it may notbe repaid, it is considered a gift and not a loan. You cannot take abad debt deduction for a gift. There cannot be a bad debt unless thereis a true creditor-debtor relationship between you and the person ororganization that owes you the money. When minor children borrow from their parents to pay for theirbasic needs, there is no genuine debt. A bad debt cannot be deductedfor 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 outyour cash. For example, you cannot claim a bad debt deduction forcourt-ordered child support not paid to you by your former spouse. Ifyou are a cash method taxpayer (most individuals are), you generallycannot 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 becomesworthless. You do not have to wait until a debt is due to determinewhether it is worthless. A debt becomes worthless when there is nolonger any chance that the amount owed will be paid. It is not necessary to go to court if you can show that a judgmentfrom the court would be uncollectible. You must only show that youhave taken reasonable steps to collect the debt. Bankruptcy of yourdebtor is generally good evidence of the worthlessness of at least apart of an unsecured and unpreferred debt. If your bad debt is the loss of a deposit in a financialinstitution, see Loss on deposits in an insolvent or bankruptfinancial institution, earlier. Filing a claim for refund.If you do not deduct a bad debt on your original return for theyear it becomes worthless, you can file a claim for a credit or refunddue to the bad debt. To do this, use Form 1040X to amend your returnfor the year the debt became worthless. You must file it within 7years from the date your original return for that year had to befiled, or 2 years from the date you paid the tax, whichever is later.(Claims not due to bad debts or worthless securities generally must befiled within 3 years from the date a return is filed, or 2 years fromthe date the tax is paid.) For more information about filing a claim,see Publication 556, Examination of Returns, Appeal Rights, andClaims for Refund. Loan guarantees.If you guarantee a debt that becomes worthless, you cannot take abad debt deduction for your payments on the debt unless you can showeither that your reason for making the guarantee was to protect yourinvestment or that you entered the guarantee transaction with a profitmotive. If you make the guarantee as a favor to friends and do notreceive any consideration in return, your payments are considered agift and you cannot take a deduction. Example 1.Henry Lloyd, an officer and principal shareholder of the SpruceCorporation, guaranteed payment of a bank loan the corporationreceived. The corporation defaulted on the loan and Henry made fullpayment. Because he guaranteed the loan to protect his investment inthe corporation, Henry can take a nonbusiness bad debt deduction. Example 2.Milt and John are co-workers. Milt, as a favor to John, guaranteesa note at their local credit union. John does not pay the note anddeclares bankruptcy. Milt pays off the note. However, since he did notenter into the guarantee agreement to protect an investment or to makea profit, Milt cannot take a bad debt deduction. Deductible in year paid.Unless you have rights against the borrower, discussed next, apayment you make on a loan you guaranteed is deductible in the yearyou make the payment. Rights against the borrower.When you make payment on a loan that you guaranteed, you may havethe 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 otherright to demand payment from the borrower, you cannot take a bad debtdeduction until these rights become totally worthless. Debts owed by political parties.You cannot take a nonbusiness bad debt deduction for any worthlessdebt owed to you by: A political party, A national, state, or local committee of a political party,or A committee, association, or organization that eitheraccepts contributions or spends money to influence elections. Mechanics' and suppliers' liens.Workers and material suppliers may file liens against propertybecause of debts owed by a builder or contractor. If you pay off thelien to avoid foreclosure and loss of your property, you are entitledto repayment from the builder or contractor. If the debt isuncollectible, you can take a bad debt deduction. Insolvency of contractor.You can take a bad debt deduction for the amount you deposit with acontractor if the contractor becomes insolvent and you are unable torecover your deposit. If the deposit is for work unrelated to yourtrade 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 remainsecondarily liable for repayment of the mortgage loan. If the buyerdefaults on the loan and the house is then sold for less than theamount outstanding on the mortgage, you may have to make up thedifference. You can take a bad debt deduction for the amount you payto satisfy the mortgage, if you cannot collect it from the buyer. Worthless securities. If you own securities that become totally worthless, you can take adeduction for a loss, but not for a bad debt. See WorthlessSecurities under What Is a Sale or Trade, earlier inthis chapter. How to report bad debts.Deduct nonbusiness bad debts as short-term capital losses onSchedule 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 baddebt in parentheses in column (f). Use a separate line for each baddebt. For each bad debt, attach a statement to your return that contains: A description of the debt, including the amount, and thedate it became due, The name of the debtor, and any business or familyrelationship between you and the debtor, The efforts you made to collect the debt, and Why you decided the debt was worthless. For example, youcould show that the borrower has declared bankruptcy, or that legalaction to collect would probably not result in payment of any part ofthe debt. S corporation shareholder.If you are a shareholder in an S corporation, your share of anynonbusiness bad debt will be shown on a schedule attached to yourSchedule K-1 (Form 1120S) that you receive from the corporation. 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 yourecover in your gross income. However, you can exclude from grossincome the amount recovered up to the amount of the deduction that didnot reduce your tax in the year deducted. See Recoveries inPublication 525. 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 twosteps. You sell short. You borrow property and deliverit to a buyer. Funf-Sterne Hotel Noordwijk aan ZeeYou close the sale. At a later date, you eitherbuy substantially identical property and deliver it to the lender ormake delivery out of property that you held at the time of the sale. You do not realize gain or loss until delivery of property toclose the short sale. You will have a capital gain or loss if theproperty used to close the short sale is a capital asset. Exception if property becomes worthless.A different rule applies if the property sold short becomessubstantially worthless. In that case, you must recognize gain as ifthe short sale were closed when the property became substantiallyworthless. Exception for constructive sales.Entering into a short sale may cause you to be treated as havingmade a constructive sale of property. In that case, you will have torecognize gain on the date of the constructive sale. For details, seeConstructive Sales of Appreciated Financial Positions,earlier. Example.On May 1, 2000, you bought 100 shares of Baker Corporation stockfor $1,000. On September 3, 2000, you sold short 100 shares of similarBaker stock for $1,600. You made no other transactions involving Bakerstock for the rest of 2000 and the first 30 days of 2001. Your shortsale is treated as a constructive sale of an appreciated financialposition because a sale of your Baker stock on the date of the shortsale would have resulted in a gain. You recognize a $600 short-termcapital gain from the constructive sale and your new holding period inthe Baker stock begins on September 3. Short-Term or Long-TermCapital Gain or Loss As a general rule, you determine whether you have short-term orlong-term capital gain or loss on a short sale by the amount of timeyou actually hold the property eventually delivered to the lender toclose the short sale. Example.Even though you do not own any stock of the Ace Corporation, youcontract 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 100shares of Ace Corporation stock and immediately deliver them to yourbroker to close out the short sale. Your loss is a short-term capitalloss because your holding period for the delivered property is lessthan one day. Special rules.Special rules may apply to short sales of stocks, securities, andcommodity futures (other than certain straddles). These rules limitthe circumstances for treating capital gain as long term and capitalloss as short term by taking into account certain substantiallyidentical property you held on the date of the short sale or acquiredafterwards. But if the amount of property you sold short is more thanthe amount of that substantially identical property, the special rulesdo not apply to the gain or loss on the excess. Special rules for gains and holding period.If you held the substantially identical property for 1 year or lesson the date of the short sale, or if you acquired the substantiallyidentical property after the short sale and by the date of closing theshort sale, then: Rule 1. Your gain, if any, when you close theshort sale is a short-term capital gain, and Rule 2. The holding period of the substantiallyidentical property begins on the date of the closing of the short saleor on the date of the sale of this property, whichever comes first. Special rule for treatment of losses.If, on the date of the short sale, you held substantially identicalproperty for more than 1 year, any loss you realize on the short saleis a long-term capital loss, even if you held the property used toclose the sale for 1 year or less. Certain losses on short sales ofstock or securities are also subject to wash sale treatment. Forinformation, see Wash Sales, later. Mixed straddles.Under certain elections, you can avoid the treatment of loss from ashort sale as long term under the special rule. These elections arefor positions that are part of a mixed straddle. See Otherelections under Mixed Straddles, later, for moreinformation 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 dividendpayments on your behalf while the short sale was open, that brokermust give you a Form 1099-MISC or a similarstatement, reporting the amount of these payments. Form1099-MISC must be used for those substitute payments totaling$10 or more that are known on the payment's record date to be in lieuof an exempt-interest dividend, a capital gain dividend, a return ofcapital distribution, or a dividend subject to a foreign tax credit,or that are in lieu of tax-exempt interest. Do not treat thesesubstitute payments as dividends or interest. Instead, report thesubstitute 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: Tax-exempt interest (including OID) that has accrued whilethe short sale was open, and A dividend, if the ex-dividend date is after the transfer ofstock for use in a short sale and before the closing of the shortsale. Short Sale Expenses If you borrow stock to make a short sale, you may have to remit tothe lender payments in lieu of the dividends distributed while youmaintain your short position. You can deduct these payments only ifyou hold the short sale open at least 46 days (more than 1 year in thecase of an extraordinary dividend as defined below) and you itemizeyour deductions. You deduct these expenses as investment interest on Schedule A(Form 1040). See Interest Expenses in chapter 3for moreinformation. If you close the short sale by the 45th day after the date of theshort 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 tothe lender. Instead, you must increase the basis of the stock used toclose the short sale by that amount. To determine how long a short sale is kept open, do not include anyperiod during which you hold, have an option to buy, or are under acontractual obligation to buy substantially identical stock orsecurities. If your payment is made for a liquidating distribution ornontaxable stock distribution, or if you buy more shares equal to astock distribution issued on the borrowed stock during your shortposition, you have a capital expense. You must add the payment to thecost of the stock sold short. Exception.If you close the short sale within 45 days, the deduction foramounts you pay in lieu of dividends will be disallowed only to theextent the payments are more than the amount that you receive asordinary income from the lender of the stock for the use of collateralwith the short sale. This exception does not apply to payments inplace of extraordinary dividends. Extraordinary dividends.If the amount of any dividend you receive on a share of preferredstock equals or exceeds 5% (10% in the case of other stock) of theamount realized on the short sale, the dividend you receive is anextraordinary dividend. Wash Sales You cannot deduct losses from sales or trades of stock orsecurities in a wash sale. A wash sale occurs when you sell or trade stock or securities at aloss and within 30 days before or after the sale you: Buy substantially identical stock or securities, Acquire substantially identical stock or securities in afully taxable trade, or Acquire a contract or option to buy substantially identicalstock or securities. If you sell stock and your spouse or a corporation you controlbuys substantially identical stock, you also have a wash sale. If your loss was disallowed because of the wash sale rules, add thedisallowed loss to the cost of the new stock or securities. The resultis your basis in the new stock or securities. This adjustmentpostpones the loss deduction until the disposition of the new stock orsecurities. Your holding period for the new stock or securities beginson 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 samestock for $800. Because you bought substantially identical stock, youcannot deduct your loss of $250 on the sale. However, you add thedisallowed loss ($250) to the cost of the new stock ($800) to obtainyour basis of the new stock, which is $1,050. Example 2.You are an employee of a corporation that has an incentive payplan. Under this plan, you are given 10 shares of the corporation'sstock as a bonus award. You include the fair market value of the stockin your gross income as additional pay. You later sell these shares ata loss. If you receive another bonus award of substantially identicalstock within 30 days of the sale, you cannot deduct your loss on thesale. Options and futures contracts.The wash sale rules apply to losses from sales or trades ofcontracts and options to acquire or sell stock or securities. They donot apply to losses from sales or trades of commodity futurescontracts and foreign currencies. See Coordination of LossDeferral Rules and Wash Sale Rules under Straddles,later, for information about the tax treatment of losses on thedisposition 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 samecorporation. But if you sell warrants at a loss and, at the same time,buy common stock in the same corporation, the wash sale rules applyonly if the warrants and stock are considered substantially identical,as discussed next. Substantially identical.In determining whether stock or securities are substantiallyidentical, you must consider all the facts and circumstances in yourparticular case. Ordinarily, stocks or securities of one corporationare not considered substantially identical to stocks or securities ofanother corporation. However, they may be substantially identical insome cases. For example, in a reorganization, the stocks andsecurities of the predecessor and successor corporations may besubstantially identical. Similarly, bonds or preferred stock of a corporation are notordinarily considered substantially identical to the common stock ofthe same corporation. However, where the bonds or preferred stock areconvertible into common stock of the same corporation, the relativevalues, price changes, and other circumstances may make these bonds orpreferred stock and the common stock substantially identical. Forexample, preferred stock is substantially identical to the commonstock if the preferred stock: Is convertible into common stock, Has the same voting rights as the common stock, Is subject to the same dividend restrictions, Trades at prices that do not vary significantly from theconversion ratio, and Is unrestricted as to convertibility. More or less stock bought than sold.If the number of shares of substantially identical stock orsecurities you buy within 30 days before or after the sale is eithermore or less than the number of shares you sold, you must determinethe particular shares to which the wash sale rules apply. You do thisby 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 somatched are subject to the wash sale rules. Example 1.You bought 100 shares of M stock on September 24, 1999, for $5,000.On December 21, 1999, you bought 50 shares of substantially identicalstock for $2,750. On December 28, 1999, you bought 25 shares ofsubstantially identical stock for $1,125. On January 4, 2000, you soldfor $4,000 the 100 shares you bought in September. You have a $1,000loss on the sale. However, because you bought 75 shares ofsubstantially identical stock within 30 days of the sale, you cannotdeduct the loss ($750) on 75 shares. You can deduct the loss ($250) onthe other 25 shares. The basis of the 50 shares bought on December 21,1999, is increased by two-thirds (50 75) of the $750disallowed loss. The new basis of those shares is $3,250 ($2,750 +$500). The basis of the 25 shares bought on December 28, 1999, isincreased by the rest of the loss to $1,375 ($1,125 + $250). Example 2.You bought 100 shares of M stock on September 24, 1999. On February1, 2000, you sold those shares at a $1,000 loss. On each of the 4 daysfrom February 15, 2000, to February 18, 2000, you bought 50 shares ofsubstantially identical stock. You cannot deduct your $1,000 loss. Youmust add half the disallowed loss ($500) to the basis of the 50 sharesbought on February 15. Add the other half ($500) to the basis of theshares bought on February 16. Loss and gain on same day.Loss from a wash sale of one block of stock or securities cannot beused to reduce any gains on identical blocks sold the same day. Example.During 1995, you bought 100 shares of X stock on each of threeoccasions. 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 thirdblock. On December 23, 2000, you sold 300 shares of X stock for $125 ashare. On January 6, 2001, you bought 250 shares of identical X stock.You cannot deduct the loss of $33 a share on the first block becausewithin 30 days after the date of sale you bought 250 identical sharesof X stock. In addition, you cannot reduce the gain realized on thesale 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 securitiesif the loss is from a transaction made in the ordinary course ofbusiness. Short sales. The wash sale rules apply to a loss realized on a short sale if yousell, or enter into another short sale of, substantially identicalstock or securities within a period beginning 30 days before the datethe short sale is complete and ending 30 days after that date. For purposes of the wash sale rules, a short sale is consideredcomplete on the date the short sale is entered into, if: On that date, you own stock or securities identical to thosesold short (or by that date you enter into a contract or option toacquire that stock or those securities), and You later deliver the stock or securities to close the shortsale. Otherwise, a short sale is not considered complete until theproperty is delivered to close the sale. Example.On June 2, you buy 100 shares of stock for $1,000. You sell short100 shares of the stock for $750 on October 6. On October 7, you buy100 shares of the same stock for $750. You close the short sale onNovember 17 by delivering the shares bought on June 2. You cannotdeduct the $250 loss ($1,000 - $750) because the date ofentering into the short sale (October 6) is considered the date thesale is complete for wash sale purposes and you bought substantiallyidentical stock within 30 days from that date. Residual Interests in a REMIC.The wash sale rules generally will apply to the sale of yourresidual interest in a real estate mortgage investment conduit (REMIC)if, during the period beginning 6 months before the sale of theinterest and ending 6 months after that sale, you acquire any residualinterest in any REMIC or any interest in a taxable mortgage pool thatis 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 (Form1040), whichever is appropriate. Show the full amount of the loss inparentheses in column (f). On the next line, enter "Wash Sale" incolumn (a) and the amount of the loss not allowed as a positive amountin column (f). Options Options are generally subject to the rules described in thissection. If the option is part of a straddle, the loss deferral rulescovered later under Straddles may also apply. For specialrules that apply to nonequity options and dealer equity options, seeSection 1256 Contracts Marked to Market, earlier. Gain or loss from the sale or trade of an option to buy or sellproperty that is a capital asset in your hands, or would be if youacquired it, is capital gain or loss. If the property is not, or wouldnot 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. Thestock increases in value and you sell the option for more than youpaid for it. Your gain is capital gain because the stock underlyingthe option would have been a capital asset in your hands. Example 2.The facts are the same as in Example 1, except that the stockdecreases in value and you sell the option for less than you paid forit. Your loss is a capital loss. Section 1231 transactions.If you hold an option more than 1 year to buy or sell property thatis (or would be) used for business or to produce rents or royalties,the gain or loss on its sale or trade is a section 1231 gain or loss.For information on its treatment, see Section 1231 Gains andLosses in chapter 3 of Publication 544. Option not exercised.If you do not exercise an option to buy or sell, and you have aloss, you are considered to have sold or traded the option on the datethat it expired. Writer of option.If you write (grant) an option, how you report your gain or lossdepends on whether it was exercised. If you are not in the business of writing options and an option youwrite on stocks, securities, commodities, or commodity futures is notexercised, 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 asection 1256 contract. Section 1256 contracts are defined underSection 1256 Contracts Marked to Market, earlier. Cash settlement option.A cash settlement option is treated as an option to buy or sellproperty. A cash settlement option is any option that on exercise issettled in, or could be settled in, cash or property other than theunderlying property. How to report.Gain or loss from the closing or expiration of an option that isnot a section 1256 contract, but that is a capital asset in yourhands, is reported on Schedule D (Form 1040). If an option you purchased expired, enter the expiration date incolumn (c) and write "Expired" in column (d). If an option that you wrote expired, enter the expiration date incolumn (b) and write "Expired" in column (e). Calls and Puts Calls and puts are options on securities and are covered by therules just discussed for options. The following are specificapplications of these rules to holders and writers of options that arebought, sold, or "closed out" in transactions on a nationalsecurities exchange, such as the Chicago Board Options Exchange. (Butsee Section 1256 Contracts Marked to Market, earlier, forspecial rules that may apply to nonequity options and dealer equityoptions.) These rules are also presented in Table 4-1. Calls and puts are issued by writers (grantors) to holders for cashpremiums. They are ended by exercise, closing transaction, or lapse. A call option is the right to buy from the writer of theoption, at any time before a specified future date, a stated number ofshares of stock at a specified price. Conversely, a put optionis the right to sell to the writer, at any time before aspecified 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 acapital expenditure. If you sell the call or the put before you exercise it, thedifference between its cost and the amount you receive for it iseither a long-term or short-term capital gain or loss, depending onhow long you held it. If the option expires, its cost is either a long-term or short-termcapital loss, depending on your holding period, which ends on theexpiration date. If you exercise a call, add its cost to the basis of the stock youbought. If you exercise a put, reduce your amount realized on the saleof the underlying stock by the cost of the put when figuring your gainor loss. Any gain or loss on the sale of the underlying stock is longterm or short term depending on your holding period for the underlyingstock. Put option as short sale.Buying a put option is generally treated as a short sale, and theexercise, sale, or expiration of the put is a closing of the shortsale. See Short Sales, earlier. If you have held theunderlying stock for 1 year or less at the time you buy the put, anygain on the exercise, sale, or expiration of the put is a short-termcapital gain. The same is true if you buy the underlying stock afteryou buy the put but before its exercise, sale, or expiration. Yourholding period for the underlying stock begins on the earliest of: The date you dispose of the stock, The date you exercise the put, The date you sell the put, or The date the put expires. Writers of calls and puts.If you write (grant) a call or a put, do not include the amount youreceive for writing it in your income at the time of receipt. Carry itin a deferred account until: Your obligation expires, You sell, in the case of a call, or buy, in the case of aput, the underlying stock when the option is exercised, or You engage in a closing transaction. If your obligation expires, the amount you received for writing thecall 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 amountyou received for the call when figuring your gain or loss. The gain orloss is long term or short term depending on your holding period ofthe 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 theput. 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 equalto the value of the call or put at the time of the payment, thedifference between the amount you pay and the amount you receive forthe call or put is a short-term capital gain or loss. Examples of non-dealer transactions. Expiration. Ten XYZ call options were issued onApril 8, 2000, for $4,000. These equity options expired in December2000, without being exercised. If you were a holder (buyer) of theoptions, you would recognize a short-term capital loss of $4,000 onSchedule D of your 2000 return. If you were a writer of the options,you would recognize a short-term capital gain of $4,000 on Schedule Dof your 2000 return. Closing transaction. The facts are the same as in(1), except that on May 10, 2000, the options were sold for $6,000. Ifyou were the seller, you would recognize a short-term capital gain of$2,000 on Schedule D of your 2000 return. If you were the writer ofthe options and you bought them back, you would recognize a short-termcapital loss of $2,000 on Schedule D of your 2000 return. Exercise. The facts are the same as in (1),except that the options were exercised on May 27, 2000. The buyer addsthe cost of the options to the basis of the stock bought through theexercise of the options. The writer adds the amount received fromwriting the options to the amount realized from selling thestock. Section 1256 contracts. The factsare the same as in (1),except the options were nonequity options, subject to the rules forsection 1256 contracts. If you were a buyer of the options, you wouldrecognize a short-term capital loss of $1,600, and a long-term capitalloss of $2,400. If you were a writer of the options, you wouldrecognize a short-term capital gain of $1,600, and a long-term capitalgain 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 thesale or other disposition of positions in a straddle. These rules donot 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 optionto buy and a purchased option to sell on the same number of shares ofthe security, with the same exercise price and period. Personal property.This is any property of a type that is actively traded. It includesstock options and contracts to buy stock, but generally does notinclude stock. Straddle rules for stock.Although stock is generally excluded from the definition ofpersonal property when applying the straddle rules, it is included inthe following two situations. The stock is part of a straddle in which at least one of theoffsetting positions is either: An option to buy or sell the stock or substantiallyidentical stock or securities, or A position on substantially similar or related property(other than stock). The stock is in a corporation formed or availed of to takepositions in personal property that offset positions taken by anyshareholder. Position.A position is an interest in personal property. A position can be aforward or futures contract or an option. An interest in a loan that is denominated in a foreigncurrency istreated as a position in that currency. For the straddle rules,foreign currency for which there is an active interbank market isconsidered to be actively-traded personal property. See alsoForeign currency contract under Section 1256 ContractsMarked to Market, earlier. Offsetting position.This is a position that substantially reduces any risk of loss youmay have from holding another position. However, if a position is partof a straddle that is not an identified straddle (described later), donot treat it as offsetting to a position that is part of an identifiedstraddle. Presumed offsetting positions.If you establish two or more positions, an offsetting position willbe presumed under any of the following conditions, unless otherwiserebutted. The positions are established in the same personal property(or in a contract for this property), and the value of one or morepositions varies inversely with the value of one or more of the otherpositions. The positions are in the same personal property, even ifthis property is in a substantially changed form, and the positions'values vary inversely as described in the first condition. The positions are in debt instruments with a similarmaturity, and the positions' values vary inversely as described in thefirst condition. The positions are sold or marketed as offsetting positions,whether or not the positions are called a straddle, spread, butterfly,or any similar name. The aggregate margin requirement for the positions is lowerthan the sum of the margin requirements for each position if heldseparately. Related persons.To determine if two or more positions are offsetting, you will betreated as holding any position that your spouse holds during the sameperiod. If you take into account part or all of the gain or loss for aposition 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 morepositions only to the extent that the loss is more than anyunrecognized gain you have on offsetting positions. Unused losses aretreated as sustained in the next tax year. Unrecognized gain.This is: The amount of gain you would have had on an open position ifyou had sold it on the last business day of the tax year at its fairmarket value, and The amount of gain realized on a position if, as of the endof the tax year, gain has been realized, but not recognized. Example.On July 1, 2000, you entered into a straddle. On December 16, 2000,you closed one position of the straddle at a loss of $15,000. OnDecember 31, 2000, the end of your tax year, you have an unrecognizedgain of $12,750 in the offsetting open position. On your 2000 return,your deductible loss on the position you closed is limited to $2,250($15,000 - $12,750). You must carry forward to 2001 the unusedloss of $12,750. Exceptions. The loss deferral rules just described do not apply to: A straddle that is an identified straddle at theend of the tax year, Certain straddles consisting of qualified covered calloptions and the stock to be purchased under the options, Hedging transactions, described earlier underSection 1256 Contracts Marked to Market, and Straddles consisting entirely of section 1256contracts, as described earlier under Section 1256Contracts Marked to Market (but see Identified straddle,next). Identified straddle.An identified straddle is not subject to the loss deferral rulesjust described. Instead, losses from positions in an identifiedstraddle are deferred until you dispose of all the positions in thestraddle. Any straddle (other than a straddle described in (2) or (3) above)is an identified straddle if all of the following conditions exist. You clearly identified the straddle on your records beforethe close of the day on which you acquired it. All of the original positions that you identify wereacquired on the same day. All of the positions included in item (2) were disposed ofon the same day during the tax year, or none of the positions weredisposed of by the end of the tax year. 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 straddlesif both of the following are true. All of the offsetting positions consist of one or morequalified covered call options and the stock to be purchased from youunder the options. The straddle is not part of a larger straddle. But see Special year-end rule, later, for anexception. A qualified covered call option is any option you grant to purchasestock you hold (or stock you acquire in connection with granting theoption), but only if all of the following are true. The option is traded on a national securities exchange orother market approved by the Secretary of the Treasury. The option is granted more than 30 days before itsexpiration date. The option is not a deep-in-the-money option. You are not an options dealer who granted the option inconnection with your activity of dealing in options. Gain or loss on the option is capital gain or loss. A deep-in-the-money option isan option with a strikeprice lower than the lowest qualified benchmark (LQB). The strikeprice is the price at which the option is to be exercised. The LQB isthe highest available strike price that is less than the applicablestock price. However, the LQB for an option with a term of more than90 days and a strike price of more than $50 is the second highestavailable 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 flexibleterms does not affect the determination of the LQB for an option thatis not an equity option with flexible terms. The applicable stock price for any stock for which anoption has been granted is: The closing price of the stock on the most recent day onwhich that stock was traded before the date on which the option wasgranted, or The opening price of the stock on the day on which theoption was granted, but only if that price is greater than 110% of theprice determined in (1). If the applicable stock price is $25 or less, the LQB will betreated as not less than 85% of the applicable stock price. If theapplicable stock price is $150 or less, the LQB will be treated as notless than an amount that is $10 below the applicable stock price. Example.On May 13, 2000, you held XYZ stock and you wrote an XYZ/Septembercall option with a strike price of $120. The closing price of oneshare of XYZ stock on May 12, 2000, was $130 1/4. Thestrike prices of all XYZ/September call options offered on May 13,2000, were as follows: $110, $115, $120, $125, $130, and $135. Becausethe option has a term of more than 90 days, the LQB is $125, thesecond highest strike price that is less than $130 1/4,the applicable stock price. The call option is a deep-in-the-moneyoption because its strike price is lower than the LQB. Therefore, theoption is not a qualified covered call option, and the loss deferralrules apply if you closed out the option or the stock at a loss duringthe year. Capital loss on qualified covered call options.If you hold stock and you write a qualified covered call option onthat stock with a strike price less than the applicable stock price,treat any loss from the option as long-term capital loss if, at thetime the loss was realized, gain on the sale or exchange of the stockwould be treated as long-term capital gain. The holding period of thestock does not include any period during which you are the writer ofthe option. Special year-end rule.The loss deferral rules for straddles apply if all of the followingare true. The qualified covered call options are closed or the stockis disposed of at a loss during any tax year. Gain on disposition of the stock or gain on the options isincludible in gross income in a later tax year. The stock or options were held less than 30 days after theclosing of the options or the disposition of the stock. How To Report Gainsand Losses (Form 6781) Report each position (whether or not it is part of a straddle) onwhich you have unrecognized gain at the end of the tax year and theamount of this unrecognized gain in Part III of Form 6781.Use Part II of Form 6781 to figure yourgains and losses on straddles before entering these amounts onSchedule D (Form 1040). Include a copy of Form 6781 with your incometax return. Coordination of Loss Deferral Rules and Wash Sale Rules Rules similar to the wash sale rules apply to any disposition of aposition or positions of a straddle. First apply Rule 1, explainednext, then apply Rule 2. However, Rule 1 applies only if stocks orsecurities make up a position that is part of the straddle. If aposition in the straddle does not include stock or securities, useRule 2. Rule 1.You cannot deduct a loss on the disposition of shares of stock orsecurities that make up the positions of a straddle if, within aperiod beginning 30 days before the date of that disposition andending 30 days after that date, you acquired substantially identicalstock or securities. Instead, the loss will be carried over to thefollowing tax year, subject to any further application of Rule 1 inthat year. This rule will also apply if you entered into a contract oroption to acquire the stock or securities within the time perioddescribed above. See Loss carryover, later, for moreinformation about how to treat the loss in the following tax year. Dealers.If you are a dealer in stock or securities, this loss treatmentwill not apply to any losses you sustained in the ordinary course ofyour business. Example.You are not a dealer in stock or securities. On December 2, 2000,you bought stock in XX Corporation (XX stock) and an offsetting putoption. On December 13, 2000, there was $20 of unrealized gain in theput option and you sold the XX stock at a $20 loss. By December 16,2000, the value of the put option had declined, eliminating allunrealized gain in the position. On December 16, 2000, you bought asecond XX stock position that is substantially identical to the XXstock you sold on December 13, 2000. At the end of the year there isno unrecognized gain in the put option or in the XX stock. Under thesecircumstances, the $20 loss will be disallowed for 2000 under Rule 1because, within a period beginning 30 days before December 13, 2000,and ending 30 days after that date, you bought stock substantiallyidentical to the XX stock you sold. Rule 2.You cannot deduct a loss on the disposition of less than all of thepositions of a straddle (your loss position) to the extent that anyunrecognized gain at the close of the tax year in one or more of thefollowing positions is more than the amount of any loss disallowedunder Rule 1: Successor positions, Offsetting positions to the loss position, or Offsetting positions to any successor position. Successor position.A successor position is a position that is or was at any timeoffsetting to a second position, if both of the following conditionsare met. The second position was offsetting to the loss position thatwas sold. The successor position is entered into during a periodbeginning 30 days before, and ending 30 days after, the sale of theloss position. Example 1.On November 1, 2000, you entered into offsetting long and shortpositions in non-section 1256 contracts. On November 12, 2000, youdisposed of the long position at a $10 loss. On November 14, 2000, youentered into a new long position (successor position) that isoffsetting to the retained short position, but that is notsubstantially identical to the long position disposed of on November12, 2000. You held both positions through year end, at which timethere was $10 of unrecognized gain in the successor long position andno unrecognized gain in the offsetting short position. Under thesecircumstances, the entire $10 loss will be disallowed for 2000 becausethere 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 youhave $4 of unrecognized gain in the successor long position and $6 ofunrecognized gain in the offsetting short position. Under thesecircumstances, the entire $10 loss will be disallowed for 2000 becausethere is a total of $10 of unrecognized gain in the successor longposition and offsetting short position. Example 3.The facts are the same as in Example 1, except that at year end youhave $8 of unrecognized gain in the successor long position and $8 ofunrecognized loss in the offsetting short position. Under thesecircumstances, $8 of the total $10 realized loss will be disallowedfor 2000 because there is $8 of unrecognized gain in the successorlong position. Loss carryover.If you have a disallowed loss that resulted from applying Rule 1and Rule 2, you must carry it over to the next tax year and apply Rule1 and Rule 2 to that carryover loss. For example, a loss disallowed in1999 under Rule 1 will not be allowed in 2000, unless thesubstantially identical stock or securities (which caused the loss tobe disallowed in 1999) were disposed of during 2000. In addition, thecarryover loss will not be allowed in 2000 if Rule 1 or Rule 2disallows it. Example.The facts are the same as in the example under Rule 1 above, exceptthat on December 31, 2001, you sell the XX stock at a $20 loss andthere is $40 of unrecognized gain in the put option. Under thesecircumstances, you cannot deduct in 2001 either the $20 lossdisallowed in 2000 or the $20 loss you incurred for the December 31,2001, sale of XX stock. Rule 1 does not apply because thesubstantially identical XX stock was sold during the year and nosubstantially identical stock or securities were bought within the61-day period. However, Rule 2 does apply because there is $40of unrecognized gain in the put option, an offsetting position to theloss positions. Capital loss carryover.If the sale of a loss position would have resulted in a capitalloss, you treat the carryover loss as a capital loss on the date it isallowed, even if you would treat the gain or loss on any successorpositions as ordinary income or loss. Likewise, if the sale of a lossposition (in the case of section 1256 contracts) would have resultedin a 60% long-term capital loss and a 40% short-term capital loss, youtreat the carryover loss under the 60/40 rule, even if you would treatany gain or loss on any successor positions as 100% long-term orshort-term capital gain or loss. Exceptions.The rules for coordinating straddle losses and wash sales do notapply to the following loss situations. Loss on the sale of one or more positions in a hedgingtransaction. (Hedging transactions are described under Section1256 Contracts Marked to Market, earlier.) Loss on the sale of a loss position in a mixed straddleaccount. (See the discussion later on the mixed straddle accountelection.) Loss on the sale of a position that is part of a straddleconsisting only of section 1256 contracts. Holding Period andLoss Treatment Rules The holding period of a position in a straddle generally begins noearlier than the date on which the straddle ends (the date you nolonger hold an offsetting position). This rule does not apply to anyposition you held more than 1 year before you established thestraddle. But see Exceptions, later. Example.On March 6, 1999, you acquired gold. On January 4, 2000, youentered into an offsetting short gold forward contract (nonregulatedfutures contract). On April 1, 2000, you disposed of the short goldforward contract at no gain or loss. On April 8, 2000, you sold thegold at a gain. Because the gold had been held for 1 year or lessbefore the offsetting short position was entered into, the holdingperiod for the gold begins on April 1, 2000, the date the straddleended. Gain recognized on the sale of the gold will be treated asshort-term capital gain. Loss treatment.Treat the loss on the sale of one or more positions (the lossposition) of a straddle as a long-term capital loss if both of thefollowing are true. You held (directly or indirectly) one or more offsettingpositions to the loss position on the date you entered into the lossposition. You would have treated all gain or loss on one or more ofthe straddle positions as long-term capital gain or loss if you hadsold these positions on the day you entered into the lossposition. Mixed straddles.Special rules apply to a loss position that is part of a mixedstraddle and that is a non-section 1256 position. A mixedstraddle is a straddle: That is not part of a larger straddle, In which all positions are held as capital assets, In which at least one (but not all) of the positions is asection 1256 contract, and For which the mixed straddle election (Election A, discussedlater) has not been made. Treat the loss as 60% long-term capital loss and 40% short-termcapital loss, if all of the following conditions apply. Gain or loss from the sale of one or more of the straddlepositions that are section 1256 contracts would be considered gain orloss from the sale or exchange of a capital asset. The sale of no position in the straddle, other than asection 1256 contract, would result in a long-term capital gain orloss. You have not made a straddle-by-straddle identificationelection (Election B) or mixed straddle account election (Election C),both discussed later. Example.On March 1, 2000, you entered into a long gold forward contract. OnJuly 15, 2000, you entered into an offsetting short gold regulatedfutures contract. You did not make an election to offset gains andlosses from positions in a mixed straddle. On August 9, 2000, youdisposed of the long forward contract at a loss. Because the goldforward contract was part of a mixed straddle and the disposition ofthis non-section 1256 position would not result in long-term capitalloss, the loss recognized on the termination of the gold forwardcontract will be treated as a 60% long-term and 40% short-term capitalloss. Exceptions.The special holding period and loss treatment for straddlepositions does not apply to positions that: Constitute part of a hedging transaction, Are included in a straddle consisting only of section 1256contracts, or 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 ofthe elections described in the following discussions, report your gainor loss as indicated in those discussions. If you do not make any ofthe elections, report your gain or loss in Part II of Form 6781. Ifyou disposed of the section 1256 component of the straddle, enter therecognized 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 11or 13 (Part II). Mixed straddle election (Election A). You can elect out of the marked to market rules, discussed underSection 1256 Contracts Marked to Market, earlier, for allsection 1256 contracts that are part of a mixed straddle. Instead, thegain and loss rules for straddles will apply to these contracts.However, if you make this election for an option on a section 1256contract, the gain or loss treatment discussed earlier underOptions will apply, subject to the gain and loss rules forstraddles. You can make this election if: At least 1 (but not all) of the positions is a section 1256contract, and Each position forming part of the straddle is clearlyidentified as being part of that straddle on the day the first section1256 contract forming part of the straddle is acquired. If you make this election, it will apply for all later years aswell. It cannot be revoked without the consent of the IRS. If you madethis election, check box A of Form 6781. Do not report the section1256 component in Part I. Other elections.You can avoid the 60% long-term capital loss treatment required fora non-section 1256 loss position that is part of a mixed straddle,described earlier, if you choose either of the two following electionsto offset gains and losses for these positions. Election B. Make a separate identification of thepositions of each mixed straddle for which you are electing thistreatment (the straddle-by-straddle identification method). Election C. Establish a mixed straddle accountfor a class of activities for which gains and losses will berecognized and offset on a periodic basis. These two elections are alternatives to the mixed straddleelection. You can choose only one of the three elections. Use Form6781 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 thatis part of the identified mixed straddle by the earlier of: The close of the day the identified mixed straddle isestablished, or The time the position is disposed of. If you dispose of a position in the mixed straddle before theend of the day on which the straddle is established, thisidentification must be made by the time you dispose of the position.You are presumed to have properly identified a mixed straddle ifindependent verification is used. The basic tax treatment of gain or loss under this election dependson which side of the straddle produced the total net gain or loss. Ifthe net gain or loss from the straddle is due to the section 1256contracts, gain or loss is treated as 60% long-term capital gain orloss and 40% short-term capital gain or loss. Enter the net gain orloss in Part I of Form 6781 and identify the election by checking boxB. 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 orloss on Part I of Schedule D and identify the election. For the specific application of the rules of this election, seeregulations section 1.1092(b)-3T. Example.On April 1, you entered into a non-section 1256 position and anoffsetting section 1256 contract. You also made a valid election totreat this straddle as an identified mixed straddle. On April 8, youdisposed of the non-section 1256 position at a $600 loss and thesection 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 thestraddle will be treated as 60% long-term capital gain and 40%short-term capital gain because it is due to the section 1256contract. Mixed straddle account (Election C).A mixed straddle account is an account for determining gains andlosses from all positions held as capital assets in a designated classof activities at the time you elected to establish the account. Youmust establish a separate mixed straddle account for each separatedesignated class of activities. Generally, you must determine gain or loss for each position in amixed straddle account as of the close of each business day of the taxyear. You offset the net section 1256 contracts against the netnon-section 1256 positions to determine the "daily account net gainor 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 dailyaccount amount is due to section 1256 contracts, the amount is treatedas 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 thedaily account amounts for that account for the tax year. The "totalannual account net gain or loss" is determined by netting theannual account amounts for all mixed straddle accounts that you hadestablished. The net amounts keep their long-term or short-term classification.However, no more than 50% of the total annual account net gain for thetax year can be treated as long-term capital gain. Any remaining gainis treated as short-term capital gain. Also, no more than 40% of thetotal annual account net loss can be treated as short-term capitalloss. Any remaining loss is treated as long-term capital loss. The election to establish one or more mixed straddle accounts foreach tax year must be made by the due date (without extensions) ofyour income tax return for the immediately preceding tax year. If youbegin trading in a new class of activities during a tax year, you mustmake the election for the new class of activities by the later ofeither: The due date of your return for the immediately precedingtax year (without extensions), or 60 days after you entered into the first mixed straddle inthe new class of activities. You make the election on Form 6781 by checking box C. Attach Form6781 to your income tax return for the immediately preceding tax year,or file it within 60 days, if that applies. Report the annual accountnet gain or loss from a mixed straddle account in Part II of Form6781. In addition, you must attach a statement to Form 6781specifically designating the class of activities for which a mixedstraddle account is established. For the specific application of the rules of this election, seeregulations section 1.1092(b)-4T. Interest expense and carrying charges relating to mixedstraddle account positions.You cannot deduct interest and carrying charges that are allocableto any positions held in a mixed straddle account. Treat these chargesas an adjustment to the annual account net gain or loss and allocatethem proportionately between the net short-term and the net long-termcapital gains or losses. To find the amount of interest and carrying charges that is notdeductible and that must be added to the annual account net gain orloss, apply the rules described in chapter 3under Interestexpense and carrying charges on straddles to the positions heldin the mixed straddle account. Rollover of GainFrom PubliclyTraded Securities You may qualify for a tax-free rollover of certain gains from thesale of publicly traded securities. This means that if you buy certainreplacement 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 replacementproperty as described in Basis of replacement property,later. This postpones your gain until the year you dispose ofthe replacement property. discount hotels in OsloYou qualify to make this choice if you meet all the followingtests. You sell publicly traded securities at a gain. Publiclytraded securities are securities traded on an established securitiesmarket. Your gain from the sale is a capital gain. During the 60-day period beginning on the date of the sale,you buy replacement property. This replacement property must be eithercommon stock or a partnership interest in aspecialized small business investmentcompany (SSBIC). This is any partnership or corporation licensedby the Small Business Administration under section 301(d) of the SmallBusiness 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 mustrecognize gain only up to the following amount: The amount realized on the sale, minus The cost of any common stock or partnership interest in anSSBIC that you bought during the 60-day period beginning on the dateof sale (and did not previously take into account on an earlier saleof publicly traded securities). If this amount is less than the amount of your gain, you canpostpone 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, youmust recognize the full amount of your gain. Limit on gain postponed.The amount of gain you can postpone each year is limited to thesmaller of: $50,000 ($25,000 if you are married and file a separatereturn), or $500,000 ($250,000 if you are married and file a separatereturn), 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 ofyour replacement property. How to report and postpone gain.Report the entire gain realized from the sale on line 1 or line 8of Schedule D (Form 1040), whichever is appropriate. To make thechoice to postpone gain, enter "SSBIC Rollover" in column (a) ofthe line directly below the line on which you reported the gain. Enterthe amount of gain postponed in column (f). Enter it as a loss (inparentheses). Your choice is revocable with the consent of the IRS. For more information on how to postpone gain, see the Schedule D(Form 1040) instructions. Gains on QualifiedSmall Business Stock This section discusses two provisions of the law that may apply togain from the sale or trade of qualified small business stock. You mayqualify for a tax-free rollover of all or part of the gain.You may be able to exclude part of the gain from yourincome. Qualified small business stock.This is stock that meets all the following tests. It must be stock in a C corporation. It must have been originally issued after August 10,1993. As of the date the stock was issued, the corporation musthave been a qualified small business, defined later. You must have acquired the stock at its original issue,directly or through an underwriter, in exchange for money or otherproperty (not including stock), or as pay for services provided to thecorporation (other than services performed as an underwriter of thestock). In certain cases, your stock may also meet this test if youacquired it from another person who met this test, or through aconversion or trade of qualified small business stock that youheld. The corporation must have met the active businesstest, defined later, and must have been a C corporation duringsubstantially all the time you held the stock. Within the period beginning 2 years before and ending 2years after the stock was issued, the corporation cannot have boughtmore than a de minimis amount of its stock from you or a relatedparty. Within the period beginning 1 year before and ending 1 yearafter the stock was issued, the corporation cannot have bought morethan a de minimis amount of its stock from anyone, unless the totalvalue of the stock it bought is 5% or less of the total value of allits stock. For more information about tests 6 and 7, see the regulationsunder section 1202 of the Internal Revenue Code. Qualified small business.This is a C corporation with total gross assets of $50 million orless at all times after August 9, 1993, and before it issued thestock. The corporation's total gross assets immediately after itissued the stock must also be $50 million or less. When figuring the corporation's total gross assets, you must alsocount the assets of any predecessor of the corporation. In addition,you must treat all corporations that are members of the sameparent-subsidiary controlled group as one corporation. Active business test.A corporation meets this test for any period of time if, duringthat period, both the following are true. It was an eligible corporation, definedbelow. It used at least 80% (by value) of its assets in the activeconduct of at least one qualified trade or business,defined below. Exception for SSBIC.Any specialized small business investment company (SSBIC) istreated as meeting the active business test. An SSBIC is an eligiblecorporation that is licensed to operate under section 301(d) of theSmall Business Investment Act of 1958 as in effect on May 13, 1993. Eligible corporation.This is any U.S. corporation other than: A Domestic International Sales Corporation (DISC) or aformer DISC, A corporation that has made, or whose subsidiary has made,an election under section 936 of the Internal Revenue Code, concerningthe Puerto Rico and possession tax credit, A regulated investment company, A real estate investment trust (REIT), A real estate mortgage investment conduit (REMIC), A financial asset securitization investment trust (FASIT),or A cooperative. Qualified trade or business.This is any trade or business other than: One involving services performed in the fields of health,law, engineering, architecture, accounting, actuarial science,performing arts, consulting, athletics, financial services, orbrokerage services, One whose principal asset is the reputation or skill of oneor more employees, Any banking, insurance, financing, leasing, investing, orsimilar business, Any farming business (including the business of raising orharvesting trees), Any business involving the production or extraction ofproducts for which percentage depletion can be claimed, or Any business of operating a hotel, motel, restaurant, orsimilar business. Section 1045 Rollover You may qualify for a tax-free rollover of capital gain from thesale of qualified small business stock held more than 6 months. Thismeans that, if you buy certain replacement stock and make the choicedescribed in this section, you postpone part or all of your gain. You postpone the gain by adjusting the basis of the replacementstock as described in Basis of replacement stock, below.This postpones your gain until the year you dispose of the replacementstock. You can make this choice if you meet all the following tests. You buy replacement stock during the 60-day period beginningon the date of the sale. The replacement stock is qualified small businessstock. The replacement stock continues to meet the active businessrequirement for small business stock for at least the first 6 monthsafter you buy it. Amount of gain recognized.If you make the choice described in this section, you mustrecognize the capital gain only up to the following amount: The amount realized on the sale, minus The cost of any qualified small business stock you boughtduring the 60-day period beginning on the date of sale (and did notpreviously take into account on an earlier sale of qualified smallbusiness 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 ismore than the amount of your capital gain, you must recognize the fullamount of your gain. Basis of replacement stock.You must subtract the amount of postponed gain from the basis ofyour replacement stock. Holding period of replacement stock.Your holding period for the replacement stock includes your holdingperiod for the stock sold, except for the purpose of applying the6-month holding period requirement for choosing to roll over the gainon its sale. How to report gain.Report the entire gain realized from the sale on line 1 or line 8of Schedule D (Form 1040), whichever is appropriate. To make thechoice to postpone the gain, enter "Section 1045 Rollover" incolumn (a) of the line directly below the line on which you reportedthe gain. Enter the amount of gain postponed in column (f). Enter itas a loss (in parentheses). Section 1202 Exclusion You generally can exclude from your income one-half of your gainfrom the sale or trade of qualified small business stock held by youfor more than 5 years. The taxable part of your gain equal to yoursection 1202 exclusion is a 28% rate gain. See Capital Gain TaxRates, later. SSBIC stock.If the stock is specialized small business investment company(SSBIC) stock that you bought as replacement property for publiclytraded securities you sold at a gain, you must reduce the basis of thestock by the amount of any postponed gain on that earlier sale, asexplained earlier under Rollover of Gain From Publicly TradedSecurities. But do not reduce your basis by that amount whenfiguring your section 1202 exclusion. Limit on eligible gain.The amount of your gain from the stock of any one issuer that iseligible for the exclusion in 2000 is limited to the greater of: Ten times your basis in all qualified stock of the issuerthat you sold or exchanged during the year, or $10 million ($5 million for married individuals filingseparately) minus the amount of gain from the stock of the same issuerthat 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 line8 of Schedule D (Form 1040). Report an amount equal to the excludedgain in column (g). Directly below the line on which you report thegain, enter "Section 1202 exclusion" in column (a) and enter theamount of the exclusion in column (f). Enter it as a loss (inparentheses). More information. For information about additional requirements that may apply, seesection 1202 of the Internal Revenue Code.