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Covered-Calls 101

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Tax Time!

The annual deadline for filing personal tax returns arrived this week and with all the talk about tax-reduction strategies, we thought it might be a good time to review some of the rules that apply to covered-call writers. Before we get started, it's important to understand that the following information is provided as a GENERAL BACKGROUND to common tax concerns for stock and option traders. It should NOT, in any way, be construed as tax law or advice. This is a very complex subject and only your broker, accountant, and/or attorney is qualified to provide guidance about trading-related tax issues.

First and foremost: If you wish to avoid the hassle of learning about the current tax laws, write covered-calls in a qualified retirement account such as a self-directed IRA or 401(k). However, if you want to trade stocks and options in a regular (taxable) brokerage account, you should be familiar with these rules.

1) Capital gains from stocks and options are subject to taxes. Current IRS rules define stock and stock options as capital assets, thus any gain from their sale is taxable. If a stock or option is held for less than one year, the ordinary income tax rates generally apply to any gain. However, if a stock or option is held for a year or more, the gain is taxed at a lower, long-term rate. With regard to options, only LEAPS can qualify for this discounted rate and only if they are held for at least one year before being sold or exercised.

2) Stocks and options in a covered-call position are taxed separately, except when the option is exercised. This means that any profits realized from the sale and subsequent purchase, or expiration, of the covered option is subject to taxation. When an option is assigned, it becomes part of the stock position for tax purposes and the proceeds from the sale of the option are included in the closing transaction. Any stocks owned for less than one year fall under the short-term rules while those held for one year or more may be taxed at a lower rate.

3) The capital gains from a forced (by option assignment) stock sale may be postponed by purchasing new shares to cover the obligation of the short calls. This strategy can help avoid the large tax liability that occurs when an investor is required to sell a long-term portfolio stock with a substantially lower cost basis. Obviously, there are extra commission costs to consider and some tax consequences with the substitute stock. In addition, it is critical to advise the broker to deliver the newly purchased shares, rather than the existing holdings, to fulfill the assignment of the exercised options.

4) The "anti-straddle" rule for options applies to in-the-money covered-calls. The basic idea behind this regulation is to prevent mismatching of gain and loss and this objective is accomplished by allowing tax-deferral to occur only when the covered writer's position is at risk. In simple terms, writing an in-the-money option may suspend or eliminate the holding period of the stock, thus affecting its tax treatment with regard to capital gain. Since this is one of the most complicated parts of investment-related tax code, we recommend that all covered-call writers read the information provided on the IRS website.

5) The "wash sale" rule prohibits an investor from selling a stock at a loss, using that loss for a tax deduction, and then immediately repurchasing the same stock. Specifically, the law says an investor may not take a tax loss on a security sale if he has obtained the same (or a substantially similar) security thirty days before or thirty days after a sale. Typically, this rule does not affect covered-call writers however it may come into play when an investor wants to repurchase a stock shortly after it has been through an unexpected option assignment.

6) The "constructive sale" rule expands the types of transactions that are considered to be sales and thus subject to a capital gains tax. Its primary purposes are to prevent investors from locking-in investment gains without paying capital gains and to limit their ability to transfer gains from one tax period to another. According to this rule, transactions that effectively take an offsetting position to a currently owned position are considered to be constructive sales. Investors who write deep-in-the-money calls against portfolio stocks may be subject to the limitations of this rule. For more information on this subject, as well as the others discussed above, review this guide to taxes and investing.

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