Options Trading: A Tax Season Note About "Qualified" Covered Calls
Are you expecting to have a covered call exercised, resulting in a long-term capital gain on stock? That’s a great strategy, but one special tax rule might result in a short-term gain even when your holding period is longer than one year. This potential problem makes an otherwise smart strategy a potentially expensive mistake.
The federal tax rules state that an unqualified covered call tolls the count leading to the one-year holding period for stock. If your short call is unqualified, exercise could mean you are fully taxed at short-term rates. This exception to the one-year rule can be a rude awakening. A qualified covered call is usually a call that is either out of the money when opened or, if in the money, is not “deep” in. This usually means the strike cannot be more than one increment below the closing price of the underlying stock.
This odd rules comes up in a couple of ways. For example, you bought 100 shares of stock eight months ago and it currently is worth 12 points more than your basis. You plan to hold shares until the one-year period has passed so your profits will be taxed at favorable long-term rates. But you are also concerned about the possibility of a price decline; so you sell a call deep in the money with a strike 7 points below current price per share and expiring in 10 months. The rationale makes sense: If the stock price declines, you can close the short call and offset paper losses. If the call is exercised, your stock sells for 7 points lower than current value, but that nets you a 5-point long-term capital gain based on your original price. The call expires two months after you have reached your one-year threshold.
There’s only one problem. This call is probably unqualified, meaning the clock leading up to the 12-month holding period is tolled. It does not start back up until the call is closed or exercised. So if the call is exercised any time between now and expiration, your gain on the stock is going to be short-term. This is true even if the call is exercised on the last trading day, which would be 14 months after you bought shares. The rule has you at only 8 months to that point, with 4 months yet to go before you get the long-term rate.
Another danger spot happens even when you write a qualified covered call. For example, you sell a call that is out of the money. However, the stock price moves up substantially, and now is 7 points above the call’s strike. So to avoid exercise, you roll the short position forward (buy to close the short call and replace it with a later-expiring short sale). This is a good way to avoid exercise, but it also means you have replaced a qualified covered call with a new and unqualified short contract.
The two transactions -- selling and then closing the original call, and then selling the rolled call -- are considered as two different transactions for tax purposes. This is how you can unintentionally merge into that troubling unqualified range.
One situation makes the problem a non-issue. If you have a large carryover loss, your annual deduction is limited to $3,000. If you write an unqualified covered call and it is fully taxed, it is applied against the carryover loss. No tax consequences follow as long as the carryover loss is larger than the net profit.
The tax rules are complex and often not obvious. Before finalizing any strategy with short calls, make sure you know how the outcome will be taxed.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.