Options are odd devices in many ways; but one potential risk many traders are completely unaware of is the tax risk involved. Taxation for options is complicated and illogical in many respects. Know where you stand before closing out positions, to avoid having an unpleasant tax surprise.
The biggest tax issue involves “unqualified covered calls.” If you write one of these, the time leading up to qualify for long-term capital gains treatment stops, and doesn’t start again until after the short call has been closed. Meanwhile if the call is exercised, the gain is short-term and taxed at ordinary rates. Some people believe that “unqualified” means you are not allowed to write such calls. This is not so. It only means that you risk loss of long-term gains tax on the underlying stock if that stock is sold or called away.
You can accidentally create an unqualified covered call by rolling forward. For example, you write a covered call close to the money and it is qualified. But then the stock price rises and you roll the call forward to the same strike but with a later expiration. In your mind, the roll is a single strategy; but for tax purposes, it involves closing one position and opening another. If that later position in unqualified, the tax status of the underlying stock could be frozen as short-term gain.
The higher tax is not always disastrous. For example, if you have a large carryover loss -- as many people do today -- the higher taxable capital gain is sheltered from tax because the gain offsets the loss being brought forward.
A covered call is qualified under the following rules:
1. If the previous day’s close in the underlying at or below $25 per share, the qualification extends to one strike before the previous day’s close.
2. If the previous day’s close in the underlying was between $25.01 and $60, and if time to expiration is more than 30 days, qualified calls extend to one strike before the close.
3. If the previous day’s close in the underlying was between $60.01 and $150, and time to expiration is 31-90 days, qualification is one strike below the close. If expiration is more than 90 days, qualification goes to two strikes below the prior day’s close.
4. If the underlying closed over $150 and expiration occurs between 31 and 90 days, short calls are qualified to one strike below the close. If expiration is over 90 days, qualification is two strikes below.
The tax rules are complex, as you can see. There are even more rules concerning the timing of deductibility for losses on “married” positions such as straddles. In some instances, you cannot deduct a loss in the current tax year on one part of a married position. The loss has to be netted against the outcome of the remaining position in a future tax year.
Complicated enough for you? Clearly, you need to do a little research before closing any options positions without knowing the tax treatment.
Michael C. Thomsett is 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.