As an options trader, you’re in the game to make profits. Unfortunately, even though you’re the one who did all of the work, you’re not the only one who gets to enjoy your returns, as the tax man is eager to take his share of your winnings. However, there are ways to ensure that more of your investment gains remain yours.
The IRS is not necessarily in favor of postponing tax payments because of hedging strategies designed to protect your profits. But when the time comes to pay your taxes, it helps to know how to use in-the-money options to help you to stay in the money!
As a stock investor, you might be familiar with covered calls, wherein you sell to open an in-the-money call against your long stock position. That way, you’re collecting option premium upfront and making your stock work double-time.
However, the IRS wants to qualify how deeply in-the-money those calls can be to qualify for tax deferment, hence the term “qualified covered calls.” That is, you have covered calls and several other conditions are also true, including that there are more than 30 but fewer than 91 days until expiration and that the strike price of your call is at the first strike level below the closing price of the stock the day before the trade is initiated.
For example, suppose Chipotle Mexican Grill (CMG) closed at $122 today. If you owned the stock and wanted to sell a call against it, you could sell the CMG March 120 Calls.
But if the stock spikes at the open tomorrow, then you might need to use the highest-available in-the-money option strike price (i.e., the $125 Calls if the stock moves above that level but is less than $130). Any option that is deeper in-the-money is said to be lower than the IRS’ lowest qualified benchmark (LQB).
Per the IRS’ Web site: “If the applicable stock price is $25 or less, the LQB will be treated as not less than 85% of the applicable stock price. If the applicable stock price is $150 or less, the LQB will be treated as not less than an amount that is $10 below the applicable stock price.”
When it comes to tax treatment and you’ve incurred a loss with the qualified covered call, you would treat the option’s loss as a long-term capital loss. Keep in mind that you would keep the premium from the short call if the stock declines. But if the stock goes up, you have a loss on your option BUT you’re experiencing a long-term capital gain on the stock. The IRS also notes that “The holding period of the stock does not include any period during which you are the writer of the option.”
You may also choose to purchase a put to protect a long stock position. (This is known as a “married put” strategy.) Unlike the covered call, a put is purchased in anticipation of the stock price going down. And opposite of selling a slightly in-the-money call, buying a put option that is slightly out-of-the-money is acceptable by IRS standards. (Buying an in-the-money put would restart your holding period for your stock.)
It’s important to keep in mind that securities you’ve already held for 366 days are not subject to a restart in their holding period, because once you’ve qualified for long-term capital gains treatment, the die has already been cast and you will not destroy or restart the clock with additional strategies you choose to employ.
It’s also worth noting that if you are holding the securities in a tax-deferred or tax-free account, such as an IRA, Roth IRA or 401(k), then protective puts and long-term capital gains treatment are not something you need to be concerned with.
If you enjoyed this article, check out Dawn Pennington’s “Market-Makers Can Make or Break Options Trades” and “The Anatomy of a Stock Option Ticker.”
