Basic tax rules related to options contracts were covered in the previous chapter. This chapter builds on those basics and covers more advanced tax rules, including:
When an options contract is traded or expires, the reported gain or loss is almost always short-term. Standard options contracts have a maximum expiration of 9 months. A security held for one 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 can have expirations of up to 39 months. If an investor buys a LEAPS option, holds it for over a year, and then closes the position or allows it to expire, the gain or loss is long-term.
That long-term treatment applies only to long LEAPS. 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 is short a LEAPS contract for three years, the gain or loss is still short-term when the contract is closed out or expires. The idea is that short securities are not truly “held,” so they never qualify for long-term status.
We discussed how long puts protect long stock positions in the hedging strategies chapter. A long put can also affect a stock’s holding period (long-term vs. short-term). There are three common scenarios when an investor owns stock and buys a protective put.
If an investor buys the stock and the put on the same day, the position is a married put. For tax purposes, the IRS treats the stock and put as a single combined position.
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 stock’s cost basis becomes $174 per share ($170 stock purchase price + $4 put premium). Even if the put expires, there is no separate capital loss reported for the option. Instead, the $4 premium remains embedded in the stock’s cost basis, which reduces taxable gain (or increases loss) when the stock is sold.
A married put does not affect the stock’s holding period. If the stock is held for over a year, the sale produces a long-term capital gain or loss. If it’s held for one year or less, the result is short-term.
If the put is bought on a different day than the stock purchase, it can affect the stock’s holding period.
The IRS applies this rule to prevent investors from using protective puts to reduce risk while “running out the clock” to qualify for long-term treatment.
Example:
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.
At this point, the investor is close to long-term status. With the protective put in place, the investor can exercise the put and sell at $190 even if the market falls, which sharply limits downside risk.
For this reason, the IRS nullifies the stock’s holding period while the put is open. The holding period is treated as zero until the put is closed out or expires. Once the put is gone, the holding period starts again from zero.
An exception applies if the stock is already long-term when the put is purchased.
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.
Because the stock has already reached long-term status (more than one year held), buying the put does not affect the holding period.
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 create a deductible capital loss and then quickly buying back the same position.
For example:
January 20th
March 15th
March 16th
Here, the investor sold at a loss and repurchased the shares the next day. The IRS treats this as a wash sale because the investor has effectively maintained the same investment while attempting to claim a tax loss.
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.
The investor realizes a $22 per share loss on April 20th ($50 − $28), or $2,200 total. Because the investor repurchases the fund 15 days later, the $22 per share loss is disallowed and cannot be used as a current tax deduction.
The loss isn’t gone permanently. Instead, the disallowed loss is added to the cost basis of the new shares. Although the investor paid $30 per share on May 5th, the adjusted cost basis becomes $52 per share ($30 + $22 disallowed loss). If the investor later sells at $30, the sale would reflect a $22 per share loss ($30 proceeds vs. $52 basis). If the investor does not repurchase again within 30 days of that later sale, the loss can be recognized.
While the wash sale rule applies to stock repurchases, certain options transactions can create similar consequences. Using the same idea (buy at $50, sell at $28 for a $22 loss), 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 treats these actions as equivalent to purchasing stock (because exercise would result in buying shares). Therefore, if either contract is entered into within 30 days of the stock sale at a loss, 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 can affect the holding period of a long stock position, a short covered call can also affect the stock’s holding period. The impact depends on whether the covered call is qualified or non-qualified.
A qualified covered call has 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 that is currently 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 resumes*.
*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 again from zero.
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