June 17, 2003

Tax Rules on Stocks and Stock Options
by John Brasher, CallWriter Publisher
 

We get tax questions occasionally, and thought this as good a time as any to address the issue. Federal taxation of stock and option transactions isn't rocket science, but you do have to pay attention. The following article is only a brief and highly simplified orientation to the tax issues. It is not tax advice! Besides, these rules change. Please consult your own attorney, accountant or tax preparer about these issues, especially before executing a trade designed to defer taxes.

We do, however, suggest that you either spreadsheet your stock and option trades or use one of the many pieces of software out there specifically designed for keeping track of trades. For more tax information, visit the CBOE site.

The Ground Rules

Under current IRS rules, both stock and stock options are capital assets, and any gain on their sale is taxable. If the stock or option was held for less than a year, then ordinary income tax rates apply to the gain. But If the stock or option has been held for at least one(1) year, the holder gets a tax break on the sale, because the gain is taxed at the long-term capital gains rate. Since all stock options except LEAPS options have a duration of 9 months or less you cannot hold them for a year or more, and so tax on option gains will usually be at the short-term (ordinary income tax) rates. Remember that all short-term gains and losses are combined on your tax return. But selling a covered call reduces your basis in the underlying stock, so do you report the option premium as a gain or a transaction in the underlying? It depends. The following rules lay out the considerations.

Long Options
If you buy and resell an option, the gain will be based solely on the period you held the option. Only a LEAPS option could qualify for long-term gains treatment and only if it was actually held for at least 1 year. If you exercised the option and sold the stock, same result - the cost of the option simply reduces your gain.

Covered Option Offset or Expires Worthless
If the option expires worthless or is offset (meaning you buy back the same option you sold to close the position), then the option gain is taxed as a separate security, period. The gain or loss will be treated at the appropriate short or long-term rate. The gain is the amount you sold the call for, less any amount paid to buy it back, and less trade costs.

Covered Option Assigned
If the short option is assigned, then the option transaction becomes part of the stock transaction. That is, the option premium would be added to the strike price received, less all trade costs. If the stock has been held for less than a year, then the entire transaction will be treated as short-term. If the stock has been held for 1 year or more, then the entire transaction will be treated as long-term.

Rules on the Stock Holding Period

The IRS essentially wants you to be at risk in a stock position in order to claim long-term gains on its sale, and the sale of certain covered calls will either suspend the running of the 1-year holding period, or (worse) set the clock back to zero and start the holding period over from scratch. The tax rules on the sale of covered calls are structured to enforce the government's philosophy of allowing long-term treatment of gains only where the holder was at substantial economic risk in the underlying stock during the entire holding period.

Qualified Retirement Accounts
This includes self-directed IRA and 401(k) accounts. If you do your covered-call writing in a qualified retirement account, such as a self-directed IRA or 401(k) account, you don't have to concern yourself with the tax consequences outlined below. If you make your trades in a regular taxable brokerage account, you must be familiar with these rules.

At-the-Money (ATM) Calls
These have no effect on the holding period of the underlying stock, and you don't need to be concerned about writing them, no matter what kind of account they are traded in. ATM calls are those where the stock price at the time of purchase is the same as the call's strike price.

Out-of-the-Money (OTM) Calls
These also have no effect on the holding period of the underlying stock, and you don't need to be concerned about writing them, no matter what kind of account they are traded in.

In-the-Money (ITM) Calls
This is where the rubber meets the road, since only the writing of ITM calls will affect your holding period in the underlying stock. Investors have figured out that it is possible to reduce risk and pull much of the value out of a stock by selling a deep ITM call. This "monetizes" the stock and can significantly reduce the covered call writer's risk of loss in the stock. Since IRS wants investors to be at risk for one year to claim the long-term capital gains rate, the rules provide that certain deep ITM option sales can affect your holding period in the underlying stock if it has not already been held the entire year. IRS considers ITM options to be qualified if they are only slightly ITM and non-qualified if they are deeply ITM, the naturally, the rules are slightly more complicated than that. Here are the rules, which apply only to stocks not yet held for one year:

Qualified: While the call exists, the holding period of the stock is suspended, then starts up again at the end of the option's life. Qualified calls must meet these requirements:

• Is exchange-traded
• Is written on stock already owned by the investor or purchased in connection with the sale of the call
• Have more than 30 days remaining until expiration
• The strike price can't be too far in the money:
  • the strike is no lower than the first one available below the stock's closing price on the day before the option was written
  • if the option has more than 90 days left until expiration and the strike price is more than $50, the strike is no lower than the second one below the stock's closing price on the day before the option was written
  • if written on a stock trading at $150 or less, the call must not be more than $10 in the money

All covered calls that are written will be exchange traded and meet the second requirement, as well. The requirement that the call have more than 30 days remaining is the tough one. The strike price requirement is simple: if the option has 31-90 days remaining until expiration, it can't be written more than 1 strike below yesterday's close. But if the call has more than 90 days remaining, you can go 2 strikes below yesterday's close. However, if the stock is $150 or less, you can't write more than $10 in the money no matter what.

Non-Qualified: The stock's holding period is eliminated and reset to zero. The holding period starts again when the option expires or is closed. Ouch!

Do these rules regarding qualified and non-qualified options really matter?  They matter only to someone who has not held the stock for one year yet but intends to - - in other words, a buy-and-hold investor writing calls on a portfolio stock he intends to keep or has to keep for a full year. Investors seeking a consistent monthly return may seldom write covered calls on the same stock two months in a row and will rarely hold a stock for a full year. They will pay the short-term rate on gains and thus the above rules will be irrelevant to them, just as they are to day and active traders.

Wash Sale Rule

This rule applies to all securities and prevents anyone from taking a tax loss on the sale of a security if within 30 days before or after the sale, you bought either the same or a substantially identical security. The wash sale rule exists to prevent investors from taking a loss on a stock while they still own it or in effect still own it. You can't have your cake and eat it, and the wash sale rule is similar.

Buying a deep ITM call on shares you sold within the prior 30 days would be considered the purchase of a substantially identical security. Selling a deep ITM call naked on those same shares, however, would not be a wash sale, since selling the call is not a purchase.

The wash sale rule does not prevent you from taking a loss on a stock that you bought and resold at a loss. If you buy a stock in the morning and you resell it the same day as it drops, you can of course take the loss. Day trading or active trading does not offend the wash sale rule, since you don't still own the stock. But if the same stock reversed course and you bought it again a week later, you couldn't take the first loss until you sold the most recently purchased shares.

Good luck and good trading!