About a year ago I presented a series of articles on the above topic, primarily as an introduction, but with enough depth to offer some useful information for the typical individual investor. The original series came out just prior to the dramatic eleventh-hour legislative compromise reached at the end of 2012. In this article I will recap the changes affecting investors embedded in this legislation, plus I will expand upon several sub-topics addressed in the earlier articles, in an effort to further clarify some fairly knotty issues raised. The original six articles, with links, were:
The American Taxpayer Relief Act of 2012 - Investor Impact
The reduced tax rates for qualified dividends and long term capital gains, set to expire after 2012, were made permanent. The number of tax brackets was expanded, and a new, slightly higher rate (for qualified dividends and long term capital gains) was added for taxpayers in the new, highest bracket. Specifically, the reduced qualified dividend and long term capital gains rates are zero for taxpayers in the 10% - 15% brackets, 15% for the 25%, 28%, 33%, and 35% brackets, and 20% for taxpayers in the new 39.6% bracket. All other rules regarding qualification of dividends for the reduced rates remain intact. The new 3.8% tax on net investment income, for higher income taxpayers, was not affected by the year end deal, and will be effective starting in 2013.
Another update that has recently been announced by the IRS regarding the ongoing implementation of the Emergency Economic Stabilization Act of 2008, affecting brokerage cost basis reporting of "covered securities" transactions on Form 1099-B, is that the expansion of cost basis reporting to include options, debt securities, and all other financial instruments has been delayed to tax year 2014 reporting. It was originally supposed to go into effect for tax year 2013. For 2013, investors will report options trades on form 8949 as "non-covered securities", same as before.
Clarification on Investor Interest Deduction
The discussion in the first article, regarding deductible investor interest expense, needs further clarification:
Interest expenses for investors, such as margin interest or interest on debt to carry investments, is deductible to the extent that the investor has offsetting investment income, which is usually confined to interest or non-qualified dividends. An investor must itemize deductions on Schedule A to take advantage of this deduction. Form 4952 is usually completed to determine the investment interest deduction, but it can be omitted if investor interest is not more than the offsetting investor income from interest and ordinary dividends, there are no other investor expenses, and there is no carryover of investment interest expense from the prior year.
If there are other investment expenses, they may be used to reduce the investment income available, and thus, the investment interest that may be deducted. Form 4952 is required in this case. These expenses only have an effect if, when combined with all other miscellaneous itemized deductions, they exceed 2% of Adjusted gross Income [AGI]. See the Form 4952 Instructions for details.
Clarification of Qualified Dividend Holding Period Requirement and Possible Disqualification if Off-Setting Position Held
The second article in the original series, on Dividends, explained adequately the 60 day holding period requirement during the 121 day period encompassing the ex-dividend date, for a dividend to be qualified, so I won't repeat it here. The sixth article in the series, Straddles and Covered Calls, explained as well as this author can produce the somewhat involved rules for ensuring that a covered call written against long stock is exempt from the IRS straddle rules. A call that is compliant as explained is deemed a "qualified covered call", abbreviated henceforth in this article as a QCC. What needs more clarification is the impact of an offsetting position, other than a QCC, on the holding period requirement for dividends to be eligible for the reduced qualified dividend tax rates. First, as implied by the preceding prose, the writing of a QCC by a holder of a long stock position does not affect the holding period, as far as meeting the requirement for qualified dividend treatment. Other than a QCC, any offsetting position to the long stock holding initiated during the 121 day period encompassing the ex-dividend date causes the dividend holding period to be suspended, for as long as the offsetting position is in force. If the result is that if the stock was not held "unhedged" for the requisite 60 days during the 121 day period, the dividend received will not be a qualified dividend, because the holding period requirement was not met. The offsetting position could be a put option, a short position, or a non-qualified covered call, among other possibilities. The suspension of the holding period applies regardless of whether the stock had been held long term or short term at the point when the offsetting position was initiated.
Clarification of Holding Period for Short Term or Long Term Purposes on Long Stock, Impact of Call Option Written
The commonly used option abbreviations in the money [ITM], at the money [ATM], and out of the money [OTM] will be referenced in the following discussion.
First, if a stock was held long term at the point that the call was written, the long term status is not affected. This applies whether the call is a QCC, which is exempt from the tax straddle rules, or not. If the stock was held short term when the call was written, and the call is not a QCC, the holding period resets to zero, and does not begin to accrue until the call is closed. The call could be unqualified because it was deep ITM, had less than 30 days to expiration when initiated, or otherwise failed the QCC criteria. If the stock was held short term when the call was written, and the call meets all requirements to be a QCC, the impact on the stock holding period depends upon whether the call strike price is OTM or ATM when written, or is instead ITM at that point. If it was OTM or ATM, the stock holding period is not affected, and the holding period continues to accrue even while the option is in force. But if the call strike was ITM, the stock holding period suspends while the call is in force, resuming where it left off only when the call is closed. All of these scenarios are per Appendix 2 of the Options Industry Council guide, Options and Taxes for the Individual Investor, available here.
One further quirk to be aware of when writing calls against stock held long term at the point of initiating the QCC with a strike price ITM, is that a subsequent loss on the option, by a closing transaction, is to be reported as a long term loss, contrary to the usual rule for short option trades always being short term gains or losses regardless of how long they were open.
Various Other Omissions / Corrections / Clarifications
In the first article, in discussing migrating from being an investor to an active trader, and establishing a trading business to be reported on Schedule C, it should have been noted that a trader in securities is not liable for self employment tax. This is so whether or not a Section 475(f) mark to market election has been made.
In the Capital Gains and Losses article, the Form 8949 code to use when making an adjustment because the 1099B shows gross sales proceeds, excluding selling expenses, is 'E'. The article incorrectly stated 'O' was the code to use. IRS Publication 550, Investment Income and Expenses, and the Form 8949 Instructions both correctly show an 'E' as the proper code to use. This is the only actual error that I am aware of in the original article series, at least so far.
The line-by-line reporting for Form 8949 can be avoided in at least one case, whereby a position in a stock was acquired incrementally, in several transactions, and then sold all at once, and all of the acquisition dates, when considered against the sale date, are long term or short term. In this case, enter 'VARIOUS' for the Date Acquired, and enter the total cost of all purchases, including commissions, in the Cost Basis column. This example is in IRS Publication 550. Logically, one would think such summarization would be allowed for both sides, acquisitions and dispositions, as long as all transactions are long term or short term, but I would not assume this. The IRS may want to see details on the Sales columns matching the 1099B reporting. At any rate, no other examples other than the case just alluded to are shown in Publication 550.
More Background and Detail on IRS Straddle Rules and Impacts
My final article in the original series touched upon tax straddles and the covered call exception. There are very detailed rules, as explained in the article, to be followed for ensuring that covered calls are qualified covered calls, and are thus outside the purview of the straddle rules. Following is a brief recap of the evolution of these rules, and some further clarification of the possible impact on an investor. Form 6781 comes into play with tax straddles, and also for index options trades, the latter being considered as Section 1256 contracts.
The Economic Recovery Tax Act of 1981 created the first iteration of Section 1092, which houses the IRS tax straddle rules. Prior to that time, the realization principle was the operative rule in taxation of capital income, in that taxable income, gains or losses, could only be recognized when positions were closed. The taxation state of mind that resulted in the straddle rules was the thinking that sole reliance on the realization principle meant that capital income taxation had become optional, with losses taken currently, and gains deferred indefinitely, by savvy investors. The immediate problem the initial legislation addressed was the use of futures contracts to create artificial losses via economically offsetting positions. With the growth of options, the rules were expanded in 1984 to encompass options and stocks, and the QCC was defined as an allowable exception. The Taxpayer Relief Act of 1997 further expanded the rules, and eliminated the "short against the box" strategy, among others, with the new rules for constructive sale of an appreciated financial position. (Traders were given an "out" by the introduction of Section 475(f) mark to market status, new with the 1997 changes.) The American Jobs Creation Act of 2004 expanded the rules further, eliminating stock exceptions, except for QCCs, and revised the handling of "identified straddles". No doubt, the "cat and mouse" game between the IRS and tax strategists will continue on into the future. The straddle rules as presently construed are not adequately defined / articulated by the IRS, in the view of most tax practitioners, yet are becoming more and more impactful, as the numbers and types of derivatives and funds available for offsets has exploded in recent years.
The basic definition of a tax straddle is any set of offsetting positions established such that the risk of the total position is substantially diminished, because components within the total position can be expected to vary inversely with market movements. With the exception of the explicitly defined covered call case, any other compound position involving stocks and / or options, with offsetting components that would be expected to move inversely, could be considered a tax straddle by the IRS. This would include the common stock / option strategies of "collars" and "married puts", plus a host of common option spread strategies, such as vertical spreads, butterflies, condors, straddles, strangles, and on and on. While an active trader electing Section 475(f) mark to market status is exempt from the tax straddle rules, active investors are left with minimal ability to hedge their portfolio positions without risking being subjected to the punitive straddle rules.
What are these punitive consequences? If a component of a straddle is disposed of at a loss, the loss can only be taken to the extent it exceeds unrealized gains in the remaining positions comprising the straddle. At year end tax time, all straddle gains and losses, both recognized and not, are reported on Form 6781, and the reportable losses, those taken in excess of unrecognized gains, if any, are determined. Losses that cannot be taken are deferred to the next and succeeding years, where the same rules apply, until all components of the straddle are disposed of. In addition to not being able to use a loss in the year it occurs, the investor is subjected to a record keeping burden. Another limitation is that investment expenses related to the straddle positions cannot be deducted, but must be capitalized by adding to the cost basis of the straddle positions to which they are allocable. The capitalized charges are reduced by income generated by positions in the straddle, such as dividends. The net capitalized expenses allocated to basis will decrease the eventual capital gain or increase the eventual capital loss upon disposition of the straddle, so they will eventually be utilized.
An "identified straddle" is a straddle where all positions of a straddle are identified as such at entry, in the investor's trading records. An example would be an options trader putting on a butterfly spread. In this case, no losses from disposed legs of the identified straddle can be used until all legs of the straddle are disposed of. The unused losses are allocated to the basis of the remaining positions which have unrecognized gains, via a formula specified by the IRS (investors can use a different method in some cases), and are only used when the entire position is liquidated.
Defining whether a straddle is an "identified straddle" or not imposes a further record-keeping burden on the investor.
If a new position is entered on the same side of the market as a closed leg of a straddle within a set time frame (30 days), while other legs of the straddle are still open, the new position is deemed a "successor position", and the loss deferral of the original closed position is also limited to the extent of any unrecognized gain in the successor position(s), as well as unrecognized gain in the original positions. If you end up being able to take losses on your taxes from closed legs of a straddle, with other legs still open, your offsets didn't work very well, it would seem.
Section 1256 contract options, which are options on broad-based indexes, are not subject to the straddle rules. This is true, even for compound positions, as long as all legs are Section 1256 contracts. An example would be an iron condor of OEX options. Open positions are marked to market at year end, reported on Form 6781, and treated as if sold and repurchased at the year end closing prices.
If a straddle is a "mixed straddle", with some, but not all, legs being Section 1256 contracts, the Section 1256 contract legs can then become subject to the straddle rules, unlike cases where all legs are Section 1256 contracts. The investor has several choices for how to report these on Form 6781, per the Form 6781 instructions.
As can be seen, creating tax straddles and reporting them properly on Form 6781 is probably not something the typical retail investor wants to be involved with. The cost of professional tax reporting assistance for these complex cases will likely be more than any investor with an account size under six figures wants to be spending on tax filing.
Avoiding tax straddles, especially non-qualified covered calls, wash sale complications, constructive receipt issues, and other problematic situations in the first place is probably the best approach for the individual investor. In such cases, the expense of enlisting a tax professional to sort out particulars can put a significant dent in overall returns, possibly more than any gains realized from the complex strategies which triggered complex tax reporting situations.
Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant investor on tax issues will save time and money, and will improve the likelihood of not inadvertently entering positions which introduce unexpected tax consequences, which can result in incorrect tax filings, unnecessary tax return preparation expenses, and possibly entanglements with the IRS.
I will reiterate once again that I am not a financial professional. I am an individual investor seeking to grow in knowledge of all aspects of investing and financial management of my own retirement funds, including tax matters. In addition to the OIC document referenced and linked earlier, other resources I have relied upon are IRS Publication 550, Form 4952 Instructions, and Form 6781 Instructions. All IRS forms and publications are available from IRS.gov. The recap of the evolution of the tax straddle rules was from a Special Report: Examining the Straddle Rules after 25 Years, available here.