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Unqualified Covered Calls

Here is a tax issue that many covered call writers might not think about, until it is too late.

No one likes surprises, especially when tax time rolls around. But if you end up writing an "unqualified" covered call, it tolls the period counting toward long-term capital gains. This is a problem, for example, if you write a covered call on stock you have held 10 months. You have a nice paper profit so you write a four-month covered call deep in the money. You figure, if it gets exercised, I get my profit plus the call premium, and as long as it doesn't expire for four months, even exercise produces long-term gain.

Wrong.

In this situation, the deep ITM covered call is "unqualified, meaning the 12-month count to the long-term holding period stops as soon as you open that call. It doesn't begin again until it is closed. But meanwhile, if the call is exercised in that 14th month, profit on the stock (and the call) is treated as short-term. This is because your period was tolled once you wrote the deep ITM covered call.

This is not a problem if you have already passed the 12-month hold, or if you have a large carryover loss, as many of us do. In this case, the profit, even short-term is offset against the carryover and the qualified or unqualified doesn't affect your taxes.

But here is how you can end up unintentionally converting a qualified into an unqualified: Let's say you sell a covered call at the money and, a month later it has moved six points in the money. With expiration looming, you want to avoid exercise so you roll it forward to the same strike expiring three months later. This is most likely now an unqualified call. As far as the tax rules go, a roll is two transactions. The buy to close on the original is a completed option trade, but the sell to open on the new position (now deep ITM) is a new one. So you have avoided exercise but set yourself up for a possible short-term gain on stock held over a year.

There is no ban on writing unqualified covered calls, and you might actually want to eat up those carryover losses by sheltering option profits. But if you don't want that, be wary of the tax rules on ITM options.

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