You will recognize much of the following information when you read it. The page references below refer to the page in the 2009 Publication 550. Throughout this discussion I will refer to capital GAINS on the optimistic assumption that you will not incur a capital LOSS. However, where you read capital gain, generally you may also read it as capital loss, or capital gain/ (loss).
Second, there are no reporting requirements for retirement account trading, so, if you are only trading in your IRA, most of this discussion does not matter. You just want your account balance to be bigger next month than it was last month.
Third, some important terms need to be defined:
Capital Asset (Pub 550 P.49): This is pretty much anything you own and use for personal, pleasure or investment purposes. The term includes such tangible assets as a boat, a coin collection, or a piece of real estate. It may also include intangible assets, such as a patent or copyright. The distinction between a capital asset and a non-capital asset is its use. Pretty much any capital asset becomes a non-capital asset if it is used in a trade or business, or is “for sale” to customers in a trade or business. (See the discussion on pages 49.and 50) Our discussion will be limited to corporate stocks and stock options.
Capital Gain (Loss) (Pub 550 P.49): A capital gain or loss is simply the difference between the proceeds of the sale and your cost basis of the asset sold. (The IRS has invented something called the “deemed sale” which will be discussed later) If you bought a stock for $25 and sold it for $30, you have a capital gain of $5. You can’t have a capital gain or loss unless you have a sale of a capital asset. However, a sale of an asset does not necessarily mean you have a capital gain or loss. Why… because every capital gain requires two parts of the transaction, a sale AND an acquisition, or purchase. (See Sort Sales below):
Short Sale (Pub 550 P.56): The normal progression of a trade is to buy the security, wait, and then sell it. Well, in the world of Wall Street, you are allowed to do the trade in the reverse. A short sale of a stock is where you borrow shares from your broker and sell them, with the understanding that you will purchase the stock at a future date and return the shares. When you sell a call option, either naked, or covered by shares of the underlying stock, you are opening a short sale. The sale transaction does not constitute income or an adjustment to the basis of the stock. If the call is “bought to close” it becomes a reportable capital gain. If the call option is exercised by the buyer, the option premium becomes part of the stock sale. (See Basis) below. You may be required to report the sale on your tax return as part of a reconciliation to the Schedule D. New reporting requirements will have your broker reporting option sales to the IRS. If you sell a January call option in December, you may have to explain why you are not reporting a gain on the option sale. Make sure your tax preparer understands short sales.
New IRS reporting: For years the Form 1099-B reports covered just the sales of stock and mutual fund shares. Beginning in 2011 these reports will also include your cost basis. It is important that you check your broker statements to be sure that the cost basis of all of your securities is correct. This is going to include securities transferred between brokers and shares you receive as gifts or inheritance. At this time I do not know how a short sale will be reported. When the 2011 forms come out I will put a posting on the blog that week.
Basis (Pub 550 P.42): Basis is often a moving target. Generally it is what you paid for a stock or option. There are adjustments which may be necessary to report the proper capital gain. These adjustments may include special dividends, stock splits and stock dividends, and some others. I urge you to read the basis discussions in Publication 550. You should also keep an eye on your brokerage account because the IRS is going to assume the broker is providing the correct basis.
If you write a covered call, and it is exercised, the option premium is added to the proceeds of the sale of the stock. Example: you buy 100 shares of ABC stock for $3,800 and sell the JUL $40 call for $125. If the stock gets called away, the proceeds will be $4,125 ($4,000 + $125), and the basis will be the $3,800 you paid for the stock. The broker probably will report it properly. Just be sure they don’t report the option sale, and then report the stock exercise including the option premium.
Since this blog is for covered call writers, I will not go into the adjustments for a call purchaser or a put option transactions. If you want to learn about them see Pub 550, Page 58. There is an excellent table for treatment of option transactions.
Wash Sale (Pub 550 P.56): A wash sale loss is not deductible. A wash sale occurs when you sell a stock for a loss and, within 30 days before or after the trade, buy the same stock, or substantially the same stock. This means that if you sell a stock at $35 for a loss, and buy a $35 call option, you have a wash sale and cannot deduct the loss on the stock.
Short term vs. Long term (Pub 550 P.53): One of the reasons to keep up to date on the tax rules is because they are subject to change. A Long term gain is currently a gain on a security held for more then one year. If you have owned a stock for more than one year which is called away in an option exercise, the gain is a long term gain. It does not matter if the option was sold day before yesterday.
Schedule D: It would be wise for you to get a copy of Schedule D for Form 1040, and the instructions. Familiarize yourself with the reporting requirements so you know when the information is correct or does not look right.
Inherited Stock: The estate tax issue is still being discussed in Washington. At this pint in time, if you inherit stock from someone who died in 2010 you inherit it at the deceased person’s cost basis. If you inherited it before 2010 your cost basis is the average price of the stock on the day the person died.
If you have a simple question that you think everyone could benefit from, please post a comment on the blog. If you have a question that you would like a more personal answer to you may email me at [email protected]. If you ask too many questions, please send me your name and address so I can send you a bill. Best of luck in your trading.
Owen Sargent is an outstanding CPA, an attorney and a seasoned stock investor. He helped me develop the Ellman Calculator and is a frequent contributor to the BCI blog forum. If you are in need of a tax advisor I recommend Owen without hesitation.
Welcome New BCI Members:
It is quite humbling for me to see how many new members this site is attracting. My team and I value each and every one of our fellow Blue Collar Investors. One of our mission statements is to assist each other. At the end of each blog article is a “comments” box where you can ask questions or make statements. We encourage you to do so. Every question or comment from every member is important whether it was asked for the first time or the 100th time; whether it’s basic or advanced. Responses may be from me (admin), members of my team or other members who are part of our common goal of becoming CEOs of our own money and financial independence. WELCOME AND JOIN IN!
This is the last week of the DVD holiday sale. If you are sending this as a Christmas gift (or purchasing for yourself) it will be shipped via expedited mail at no charge and will arrive in time for the holiday if ordered by December 20th. Premium members enter the store from your premium site for an additional discount. Link to Blue Collar store:
New rolling strategies video:
I recently produced a video about expiration Friday rolling strategies based on an article I previously published. With expiration Friday coming up this week I have highlighted this video on our homepage and will continue to do so the week before each expiration Friday. I hope you find it helpful:
Economic reports continue to point to a slow but palpable recovery:
- Consumer sentiment improved as consumer borrowing rose $3.4 billion in October, the largest increase since July, 2008.
- New jobless claims decreased
- The trade deficit dropped by 13% in October
- U.S. exports jumped to their highest level in two years. Exports to China rose nearly 30%
- On a negative note, mortgage rates rose to their highest levels since June due to volatility in the fixed income markets
For the week, the S&P 500 rose 1.3% to a 2-year high of 1240 for a year-to-date return of 13.4%.
This week I constructed a 3-month line chart of the S&P 500 using the same technical indicators we use for 1-month options:
Note the following technicals:
- The blue and green arrows show an uptrending S&P 500
- The short-term moving average is above the longer-term moving average (red arrows)
- The red circle highlights where the S&P 500 moves above the short term moving average and holds there
- The blue circle shows a bullish MACD signal
- The orange arrow shows an ascending stochastic oscillator
- The green circle highlights that these positive parameters occurred on solid volume
IBD: Market in confirmed uptrend
BCI: This site continues to have a moderately bullish market outlook and as a result favor O-T-M strikes in our option sales.
The best in trading to all,