4.4.2 Advanced rules
Basic tax rules related to options contracts were covered in the previous chapter. We’ll examine more complex and advanced tax rules in this chapter, including:
When an options contract is traded or expires, the reported gain or loss is almost always short-term. Standard contracts maintain a maximum expiration of 9 months. A security held for a year or less is considered short-term and is subject to higher tax rates.
While most options contracts expire in nine months or less from issuance, Long Term Equity Anticipation Securities (LEAPS) contracts maintain expirations of up to 39 months. If an investor buys a LEAPS option, holds it for over a year, closes the position or allows it to expire, a long-term gain or loss is realized.
While this is true for long LEAPS contracts, it does not apply to short LEAPS. The Internal Revenue Service (IRS) does not consider any short security (including short stock) eligible for a long-term holding period. Even if an investor goes short LEAPS for three years, a short-term gain or loss is realized when the contract is closed out or expires. The belief is short securities are never truly “held,” which always leads to a short-term holding period.
We discussed how long puts protect long stock positions in the hedging strategies chapter. A long put can affect a stock’s holding period (long-term or short-term). There are three potential scenarios when an investor owns stock and purchases a protective put.
If an investor buys the stock and the put on the same day, the position is known as a married put. The reason for the name relates to how the position is viewed for tax purposes - it’s like the two positions come together as one. The option premium is added to the cost basis of the stock, and it’s like the option doesn’t exist (for tax purposes). For example:
An investor purchases 100 shares of WMT stock at $170 per share and goes long 1 WMT 165 put at $4 on the same day.
The cost basis of the stock is $174, which is equal to the purchase price of the stock ($170) combined with the put premium ($4). Even if the put expires, there is no capital loss reported for the option (unlike other circumstances involving an option expiration). The $4 premium is reflected in the stock’s cost basis, which reduces tax liabilities when the stock is sold (a higher cost basis results in lower gains). Married puts do not affect the stock’s holding period. If the stock is held for over a year, the sale will lock in a long-term capital gain or loss. If held for a year or less, a short-term capital gain or loss occurs.
If the put is bought on any other day than the day the stock is purchased, it can affect the holding period. Also, the put’s premium is not added to the stock’s cost basis (they’re kept separate). The IRS institutes this rule to prevent investors from taking advantage of holding period rules. Let’s explore a scenario:
An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 eleven months later, and the investor goes long 1 WMT 190 put at $6.
The IRS assumes investors are attempting to “extend” their holding period to a long-term gain without risk exposure. Think about it - even if the market price falls, the investor can exercise the put and sell the stock at $190. Being a month away from locking in a long-term gain, are they at risk of losing anything? Not really.
For this reason, the IRS nullifies and resets the investor’s holding period to zero until the put is closed out or expires. Essentially, the investor has no holding period until the put is gone. If the put is closed out or expires, the holding period starts again from zero.
One exception to the rule discussed above is if the shares were already long-term. For example:
An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 thirteen months later, and the investor goes long 1 WMT 190 put at $6.
Thirteen months into owning the stock, the stock’s holding period is already long-term. In this scenario, the holding period is unaffected.
A wash sale occurs if an investor sells a security (e.g., a stock) at a loss and repurchases it (or a substantially identical security) within 30 days of the original sale. This rule prevents investors from selling investments to lock in a deductible capital loss, only to repurchase it immediately or quickly after. For example:
January 20th
March 15th
March 16th
Although the investor sold their shares at a loss, they repurchased them the next day. Nothing significant occurred except for the $3,000 realized loss, which is deductible. The IRS feels this encourages investors to sell securities at a loss and repurchase them to obtain tax benefits. The wash sale rule was created and imposed on security transactions to prevent this type of behavior. The basics of the rule are:
Let’s run through an example:
An investor purchases 100 shares of MNO Fund at $50 per share on February 10th. On April 20th, the shares are sold for $28 per share. On May 5th, the investor buys 100 shares of MNO Fund at $30.
In this example, the investor locks in a $22 per share loss on April 20th, resulting in an overall $2,200 deductible capital loss. Fifteen days later, the investment is repurchased for $30 per share. The $22 per share loss is disallowed and cannot be used for a tax deduction.
The loss doesn’t completely evaporate, though. The disallowed loss is added to the cost basis of the new position, which helps reduce potential taxes when the investment is liquidated later. Although 100 new shares were purchased at $30, the investor will reflect a cost basis of 100 shares at $52 per share ($30 + $22 disallowed loss). If the investor were to sell their shares at the $30, they would reflect a $22 per share loss ($30 sales proceeds vs. $52 cost basis). If the investor doesn’t repurchase the shares again within 30 days, they can keep the $22 per share loss.
While the wash sale rule applies to stock repurchases, options transactions may have similar consequences. Let’s again assume an investor buys shares at $50, then later sells them at $28 (realizing a $22 loss per share). If the investor buys a call or sells a “deep in the money” put* (e.g., selling a $15 put against stock worth $28), the IRS considers these actions the same as purchasing stock (both will result in buying shares if exercised). Therefore, if either contract type is transacted within 30 days of a realized loss on stock, it triggers the wash sale rule and disallows the loss.
*The IRS does not technically define what “deep in the money” means. Therefore, there is no threshold to be aware of for the exam.
Similar to how a long put may affect the holding period of a long stock position, a short covered call may also impact the holding period. How it impacts the holding period depends on whether the covered call is qualified or non-qualified. A qualified covered call maintains the following characteristics:
*The definition of “deep in the money” is not standardized across all options contracts. In most circumstances, a call is “deep in the money” if its strike price is either $5 or $10 below the underlying stock’s market price. The specifics are unlikely to be tested.
If an investor sells an “out of the money” or “at the money” qualified covered call against a long stock position, the stock’s holding period is not affected. However, if an investor sells an “in the money” qualified covered call against a long stock position held short-term, the stock’s holding period is paused. If the call is closed out or expires and the stock position remains, the holding period is unpaused*.
*To be clear, the original holding period is not reset. For example, assume an investor goes long stock on January 1st, then sells a qualified “in the money” covered call six months later. The six-month holding period is paused until the call is closed out or expires. Assuming the call is closed out or expires, the stock’s holding period is unpaused and starts counting from the original six-month mark.
A non-qualified covered call is any covered call that does not meet the definition of ‘qualified.’ If an investor sells a non-qualified covered call against a long stock position held short-term, the stock’s holding period is reset to zero. If the call is closed out or expires, the stock’s holding period begins counting from zero.
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