President Obama has brought to the forefront the issue of taxes as a major part of his economic stimulus package. With that in mind, I thought it appropriate to discuss some of the tax issues that face covered call writers. First and foremost, let me state the obvious: I am not a tax expert. However, I do make every effort to be as informed as possible on issues that effect my hard-earned money. This article is a brief and highly simplified introduction to the tax issues, not tax advice which should be addressed with your attorney, accountant or tax preparer.
Short-term versus long-term capital assets:
Under the current IRS regulations, both stock and stock options are considered capital assets, and any gain on their sale is taxable. If the stock or option is held for less than a year, then short-term capital gains (STCG) apply. This rate would be your ordinary income tax rate up to 35%.
If the stock or option is held for at least a year, the gain is taxed at a long-term capital gains rate which is 15% for taxpayers in the 25%, 28%, 33% and 35% tax brackets. For stocks, holding periods can be affected when selling deep in-the-money strikes. This discussion is beyond the scope of this article and consultation with your tax advisor is appropriate. Since we sell predominantly 1-month options, short-term capital gains rates would apply in all non-sheltered accounts. As a matter of fact, most stock options have a duration of nine months or less, so tax rates will usually be at the short-term rates. The exception to this rule are LEAPS. These are options contracts with expiration dates that are longer than one year. Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts. The premiums for LEAPs are higher than for standard options in the same stock because of increased time value as the later expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.
What is a Capital Gain?:
This is an increase in the value of as capital asset, such as a stock or an option, that gives it a higher worth than the purchase price. It must be claimed on income taxes in non-sheltered accounts.
Rules for Covered Call Writers:
Premiums received for writing a covered call is not included in income at the time of receipt, but is held in suspense until the writer’s obligation to deliver the underlying stock expires or until the writer either sells the stock as a result of the call assignment or by closing the option position (buy-to-close). With that in mind, here are three possible scenarios that may occur after the sale of the option:
1- An expired option ( we sold the call, we didn’t close the position by buying back the option and the holder did not exercise the option) results in a short-term capital gain. For example, we sell an Apple April 90 call for $4.50 in March. The proceeds are $450. Since the cost is $0, the short-term capital gain is $450. The acquisition date will be LATER than the sales date and the word “Expired” should be written in column e, the cost basis column.
2- If we buy back the same option in the above example to close the position (usually to invoke an exit strategy), the difference between the sale profit and the buyback cost will represent a capital gain or a capital loss. As in example 1, above, the acquisition date will be LATER than the sales date.
Capital gain example: We close our position by buying back the option for $250. The capital gain is $200 ($450 – $250).
Capital loss example: We close our position by buying back the option for $550. The capital loss is $100 ($550 – $450).
3- If the option is exercised, the option transaction becomes part of the stock transaction. The option premium is added to the strike price received, less commissions. If the stock has been held for less than one year, the entire transaction will be treated as short-term. If the stock had been held for one year or more, the entire transaction will be treated as long-term as the option holding period is ignored.
The specific information referenced above can be found in IRS Publication 550 entitled Investment Income and Expenses, pages 57 – 58.
I avoid these tax issues by trading covered call stock options predominently in tax-sheltered accounts. The only exception is an account I set up specifically to neutralize a negative cash flow property I own in Florida. Last year I wrote a three-part series explaing how I do this. Here are the links to those articles:
Many thanks to Owen Sargent, an outstanding CPA and seasoned stock market investor, for his assistance with this portion of the article.
Owen Sargent, CPA
The chart patterns show a definite improvement with general market tone. The volatility index shows a consolidating chart pattern while the S&P 500 and the Banking Industry showing improving patterns. We can call this news encouraging but not conclusive. Here are the charts:
Last Weeks Economic News:
This week’s news was a mixed bag with two negatives and three positives. Let’s get the negatives out of the way first:
1- The Conference Board’s index of leading economic indicators was down 0.4% for February. This is a near term gauge of economic performance.
2- Industrial production was down 1.4% and factory output fell 0.8%. The industrial base is on track to post its worst quarterly performance in 30 years.
Now the positives:
1- The Fed announced its plan to purchase $1 trillion in long-term U.S. Treasury and mortgage-backed securities in hopes of energizing the housing industry.
2- New residential housing construction was up 22% in Februay and permits for future construction rose 3%.
3- Inflation appears to be in check as the Consumer Price Index (CPI) was just 0.1% above where it stood one year earlier.
For the week, the S&P 500 was up 1.7% for a year-to-date return of -14.3%.
I have asked my web team to enhance this site based on many of your great suggestions. In particular, I’ll be working on expanding the media library especially since I’m more comfortable working with my webcam and uploading to YouTube (not a strength of mine). I welcome all comments and suggestions in this regard.
I also have a terrific marketing team who have urged me to join Twitter (I’m “thebcinvestor“). I joined a few days ago and can be followed at this link:
Finally, many of you have asked about my new book. Significant progress has been made but there are a few changes I need the publisher to make before I give my final approval. When you see all the charts and calculations, the challenge will become crystal clear. We’re only weeks away.
Thanks for all your support,