The opening statement from Part V bears repeating, which was that options can open up a whole new world of tax complexities, if consequences of certain actions are not understood in advance. This article introduces readers to some of the more vexing consequences of running afoul of the IRS tax straddle rules. The article concludes with an in-depth discussion of covered calls, with some guidelines for avoiding entanglement in the tax straddle rules when selling covered calls.
Note that the commonly-used option terms in-the-money, at-the-money, and out-of-the-money will be abbreviated, respectively, as ITM, ATM, and OTM in the remainder of this article.
IRS "Straddle" Rules
The "straddle rules", defined in Section 1092 of the IRS code, were substantially updated in 1984, and have not changed much since then. It is important to realize that the term "straddle" as used here is much broader than the definition of a straddle position in options trading, which is merely one type of option spread position among many. The rules apply to any type of multi-legged option position, such as straddles, strangles, vertical spreads, butterflies, condors, and more. In fact, the straddle rules apply to any type of compound strategy utilizing offsetting positions, including positions where some or even all of the "legs" are stock positions. A straddle as defined by the IRS exists when an investor holds offsetting positions in substantially similar or related properties which serve to "diminish the risk of loss" because the offsetting positions are reasonably expected to vary inversely in value with market movements. Taxpayers should be aware that the IRS rules for determining when a straddle exists are not as rigid as for wash sales or constructive sales. A straddle can be said to exist even when the offsetting positions are not of the same stock or company. Mercifully, "qualified" covered calls sold against long stock are excluded from the straddle rules if the call was OTM when sold. The criteria for determining "qualified" in this case is mind-boggling, but will be addressed subsequently in this article.
An OTM protective put combined with a long stock position is also not considered a straddle by some practitioners, especially if it is a "married put", which is a put purchased simultaneously with a long stock position, or at least purchased the same day. But this exclusion is not clearly stated, and some believe it could be considered a straddle.
The purpose of the rules is to prevent sophisticated investors from taking and reporting losses in the current year, while holding on to and deferring the gains in the offsetting positions. The rules basically require that losses on a portion of a compound position taken in the current year can only be claimed to the extent that they exceed the gains in the offsetting portion of the compound position, which have presumably appreciated. The unused losses must be apportioned to the retained components of the compound position, where they can benefit the holder only when the remaining components of the compound position are disposed of. These results are reported on Form 6781, as part of the Schedule D preparation.
If the compound position was an "identified straddle", none of the losses from closed "legs" are reportable currently, even the losses in excess of gains on the offsetting positions. They can only be used to increase the basis of the retained components. An identified straddle must be noted as such when initiated in the investor's trading records, all component positions must have been entered on the same day, and the identified straddle must not be part of a larger straddle. An example would be an options trader putting on a "butterfly" or "condor" spread as one submission to a brokerage. All "legs" would be considered to be part of the compound position, as identified at entry.
Wash sale rules also apply to the options legs disposed of if the disposed positions are re-entered within 30 days. As might be suspected, when the reentered options are legs of a straddle, things can get very messy indeed.
The application of tax straddle rules can become extremely complex, depending upon the positions entered and exited, the timing, and subsequent positions entered. An additional layer of complexity is introduced if the straddle is a "mixed straddle", whereby some of the "legs" are Section 1256 contracts, such as OEX options, and some are not. Another point to note is that single stock futures are taxed similar to equity options, rather than like most types of futures contracts. It is beyond the scope of this article and this author to delve much further into the topic. The best that I can do for fellow investors is to make them aware of these issues, so nightmare situations, from a tax handling standpoint, can be avoided. Three suggestions I have are to avoid selling covered calls that are not OTM, and also be sure they have at least 30 days to go to expiration, avoid purchase of ITM or even ATM puts as protection for long stock, and enter and exit all legs of complex option spreads at one time, or at least in the same tax year.
Because of the prevalence of covered call writing by income investors, I will devote the remainder of this article to defining how to be sure a covered call written is "qualified", to avoid being impacted by the tax straddle rules.
Covered Call Impacts on Stock Holding Period, Defining Qualified Covered Calls
Covered calls which are not qualified can affect the holding period of the long stock position providing the coverage. Even covered calls that are only slightly ITM, not enough to be unqualified, can cause the holding period to be suspended for the duration of the call. Also, for as long as the distinction exists, dividends received which would nominally be considered qualified dividend income can become unqualified in certain cases if the stock has become part of a straddle because of unqualified covered call options being sold. Here are several scenarios:
- If the call is deep enough ITM to be considered an offsetting position to the long stock, thus triggering the straddle rules, and the stock had not been held for more than a year before the option was sold, the holding period of the stock position goes to zero, and only restarts after the stock is no longer subject to a straddle. As for dividends, if they are nominally qualified and the stock was held with no call in force for the requisite 61 days of the 121 day period encompassing the ex-dividend date, they are still qualified dividends.
- If the call is deep enough ITM to be considered an offsetting position to the long stock, thus triggering the straddle rules, and the stock had been held for more than a year before the option was sold, the holding period of the stock position is merely suspended while the option position exists, and resumes after the stock is no longer subject to a straddle. As for dividends, if they are nominally qualified and the stock was held with no call in force for the requisite 61 days of the 121 day period encompassing the ex-dividend date, they are still qualified dividends. Since the stock had been held long-term before the call was sold, suspension of the holding period does not affect the long-term status of the holding, but the suspension can affect the holding period for determining if dividends are qualified.
- If the call is a qualified covered call per the rules but was ITM when sold, the holding period is suspended for the period of time that the option position is open, but then resumes where it left off when the option position is closed. If the stock had already been held for more than one year when the option was sold, suspending the holding period won't affect the long-term status of the stock. Dividends are either qualified or not by the same criteria as the preceding item.
- If the call is a qualified covered call that was OTM when sold, the stock holding period is not affected. I assume this also applies to ATM, although the resource I am looking at, the BBD LLP article Part III, does not specifically address the ATM case. A link to the BBD article series is provided under Resources, below. The OIC document, also linked below, does state that a qualified ATM call is treated the same as a qualified OTM call, as far as the stock holding period is concerned.
- If the call is not a qualified covered call because of when the option was sold, but is not deep enough ITM to be considered an offsetting position triggering the straddle rules, the holding period is suspended for the period of time that the option position is open. If the stock was held less than one year when the option was sold, but not much less, and then was later sold, the holding period suspension could cause the gain or loss on the stock sale to be short-term, even though it was physically held longer than one year. This situation is described by Michael Thomsett in his article referenced below under Resources.
- The BBD LLP article Part III points out another quirk, which is if a covered call is closed at a loss, and the stock providing the coverage had been held over a year before the call was sold, the loss on the call must be reported as a long-term loss, even though it was only in play for a short time. This appears to be the rule regardless of whether the call was qualified or not.
So, to avoid complications, an investor will want covered calls sold to be qualified, and ATM or OTM if the stock holding period is a consideration. The first requirement is that the sold option position must be entered after the stock position was acquired, and must have more than 30 days to go to expiration when sold, but not more than 33 months to go. If these tests are failed, the call strike price does not matter, the call is not qualified. The second requirement is that the option cannot be "deep in the money". As in most cases, especially where the IRS is concerned, the devil is in the details. To not be considered deep in the money, the option strike price of the call sold cannot be lower than the Lowest Qualified Benchmark (LQB) price of strikes available for the option. To apply this test, the current stock price and the LQB price must both be defined more precisely. The current stock price to use is the stock's closing price on the trading day prior to the day the option was sold, unless the stock opens the next day more than 10% above the previous day's close -- in that case the current stock price to use is 110% of the previous day's close. The LQB price depends on the price range of the stock, and the time to expiration. First, consider the rules when the option's time to expiration is more than 30 days but not more 12 months:
- If the current stock price is less than or equal to $25.00, the LQB strike price is the first strike offered that is less than the current stock price, and the strike must be at least 85% of the current stock price.
- If the current stock price is in the range $25.01 to $50.00, the LQB strike price is the first strike offered that is less than the current stock price. The 85% rule no longer applies.
- If the current stock price is in the range $50.01 to $150.00, and the option has 31 to 90 days to go to expiration, the LQB strike price is the first strike offered that is less than the current stock price.
- If the current stock price is in the range $50.01 to $150.00, and the option has more than 90 days to go to expiration, the LQB strike price can be as low as the second strike offered that is less than the current stock price, but only if the strike is not more than $10.00 ITM. If the second strike is disqualified on this point, then the next strike up would be the lowest strike allowed. I would assume this higher strike also must pass the ITM test.
- If the current stock price is greater than $150.00, and the option has 31 to 90 days to go to expiration, the LQB strike price is the first strike offered that is less than the current stock price.
- If the current stock price is greater than $150.00, and the option has more than 90 days to expiration, the LQB strike price is the second strike offered that is less than the current stock price. The option sold can be at this strike or higher.
If the option's time to expiration is more than 12 months, the current stock price, as determined by the prior rules, is adjusted further by a factor which is dependent upon the time to expiration. See the OIC document referenced under Resources for the values of these factors. They are all greater than 1.00, so the effect is the adjusted current stock price is higher. This adjusted current stock price is then compared to the available strikes, and the rules above are applied. When applying the rules, the time to expiration in these cases is always more than 12 months.
One final "gotcha" comes into play with a special year-end rule regarding covered calls and long stock. If either, but not both, the stock or the option position is closed at a loss in the current tax year, and a gain on the remaining position is achieved in the succeeding tax year, and this gain occurs within 30 days of the date that the related position was exited at a loss, the loss cannot be reported in the current tax year. It must be carried over and reported the next year, along with the gain which also occurred that year.
Resources and Disclaimer
All of the preceding is based on my review of the following resources:
J.K. Lasser's Your Income Tax for 2013, available from bookstores everywhere.
Various IRS Publication, particularly the 1040 Instruction booklet, plus instructions for Schedules A, B, C, D, and E, and Publication 550, Investment Income and Expenses. A link to the IRS website is provided here.
Tax Notes Special Report - Examining the Straddle Rules After 25 Years. This report is very interesting as a distinguished list of practitioners comment on the tax straddle rules.
Tax Consequences Associated With Option Strategies, a series of articles provided by BBD, LLP, a Certified Public Accounting firm located in Philadelphia, PA. Links to Part I, Part II, Part III, and Part IV are hereby provided.
Qualified and Unqualified Covered Calls, by Michael Thomsett. Mr. Thomsett is the author of a book entitled Options Trading for the Conservative Investor, which is listed as recommended reading at my own website. To see the recommended reading list, go to Approach, then select Resources and account Management.
Covered Calls and Options - You Make The Call, available from The Motley Fool. The link is to a brief treatise authored by "zman49".
I want to note that I do not necessarily concur with all of these resources, and the deeper I go into the topic, the more I notice the experts occasionally differ from each other as well on various points. All I can suggest is to research as much as possible, and go with what seems to be the correct stance, or better yet, utilize a tax professional who is knowledgeable regarding the applicable tax rules.
While I have made a good faith effort to understand and present the topics discussed in this article, relying upon the resources cited, I want to reiterate that I am not a financial professional, nor am I certified in any way as a financial advisor or tax expert. I am an independent, individual investor, focusing on dividend-paying stocks exclusively. I am always seeking to become more knowledgeable on investments and related topics, and on sharing what I have learned with other investors in similar circumstances. Also, I want to reiterate a caution mentioned in the first paragraph of Part I and in the Disclaimer section of all succeeding articles, which is that the points I am bringing out are limited to commonly occurring situations that investors in publicly traded stocks and options experience, with positions held "in street name" in brokerage accounts. Readers need to realize that the information as presented is not all-inclusive, and that there are many exception conditions and special cases that are not discussed.
Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant client on tax issues affecting investors will save time and money, and will improve the likelihood of correct tax filings.
This concludes this somewhat ambitious series. The author's hope is that the series provides a useful introduction to the topics addressed and serves to make readers aware of the many tax-related pitfalls that can befall them if these issues are not considered ahead of time.