Disqualifying disposition (ISO)

A disqualifying disposition is any sale, gift, or transfer of ISO shares that fails either of the Section 422 holding tests: more than two years from the grant date and more than one year from the exercise date. On a disqualifying disposition, the bargain element at exercise converts from an AMT preference to ordinary wage income reported on the W-2. Any additional gain above FMV at exercise is short-term or long-term capital gain depending on the holding period from exercise to sale.

Example: 4,000 ISOs at a $6 strike exercised at $50 FMV, then sold six months later at $48. The $44 spread per share, $176,000 total, is reclassified as ordinary wages. The $2 per share loss from $50 to $48 is a short-term capital loss. Because the sale happened in the same calendar year as exercise, no AMT preference is reported on Form 6251.

Common mistake: forgetting that a same-calendar-year disqualifying disposition cancels the AMT, but a cross-year one (exercise in December, sell in January) still requires AMT paid first.

Disqualifying dispositions matter when IPO prices drop post-lockup and when an AMT reversal is worth more than long-term capital gain treatment.