Home > Blogs > Options Trading: The Mysteries of the "Qualified" Covered Call

Options Trading: The Mysteries of the "Qualified" Covered Call

By  Feb 18, 2010

Topics: Finance & Investing

Tax laws are complex, as we all know. But one of the most mind-boggling is the qualified covered call rule. If you write a call too deep in the money, the count of time to achieve long-term capital gains simply stops and doesn’t restart until; the position if closed. If this means exercise, then the stock profits are taxed at short-term rates.

This topic demands further investigation because explaining exactly how a qualified covered call is defined gets very complicated. The formula is a combination of time to expiration, strike and current value levels, and where the call resides. But as a general rule, if your covered call is more than two strikes in the money (meaning the strike is well below the stock’s current market value), the call is “unqualified.”

That does not mean you are disallowed from making the covered call write. It does mean that if your stock has been held for less than a year, you can’t use the standard one-year rule to decide when you get long-term capital gains treatment on your stock. The count of time just stops for as long as the unqualified covered call is open. If it is closed via exercise, even if your overall holding period is longer than a full year, you get fully taxed.

You can avoid this by just not writing deep in-the-money calls. But you can accidentally fall into the trap when you use the forward roll. For example, you write a call at the money and then the stock rises. To avoid exercise, you close out the original position and replace it with another call at the same strike, expiring a few months later. You might be replacing a qualified with an unqualified covered call in this strategy.

For tax reasons, the two transactions -- selling and then closing the original call, and then selling the rolled call -- are separate from one another. You report a net profit or loss on the call you closed, and the new call is a new trade as far as federal taxes are concerned. If it is unqualified, you could end up with an unpleasant surprise if your call is exercised: Short-term rates may apply instead of the lower long-term rates.

The solution to this potential problem is to study up on the oddity of option tax rules. You need to make sure you know the consequences of your forward roll before you make the decision to proceed. Even if you close out the new call before it expires and then sell your shares, you need to understand when the long-term capital gains status takes effect. It could be further out than you think.