Tax implications of covered calls

Overview of tax issues

The following discussion is a broad overview of some of the tax issues that investors who use covered calls should be aware of. Any information contained herein is not intended to be tax advice and should not be considered as such. Tax laws relating to options in general and covered calls specifically are subject to change, so you should seek the advice of a tax professional to make sure you are complying with current IRS regulations.

The information provided in this section is a summary of only a few points discussed in publications by The Options Industry Council.

Profits and losses attained from covered calls are considered capital gains. Gains and losses can come from the stock only, from the covered call only, or from a combination of the 2. A gain on a stock is realized when it is sold at a higher net price than the net price at which it was purchased. A loss on a stock is realized when the net sale price is lower than the net purchase price.

For covered calls in which the sale of the call comes first, a gain is realized when the call is repurchased at a lower net price than the net sale price. A loss on a covered call is realized when it is repurchased at a higher net price than the net price at which it was sold.

If a covered call is assigned, then the entire net profit or net loss is determined by the net purchase price and net sale price of the stock as discussed below.

One major concern for investors who use covered calls is the holding period of the stock, and some covered calls affect the holding period of the stock.

Dividends paid by the stock may also be a benefit of the covered call strategy, and some dividends qualify for favorable tax treatment if a stock is held for 61 days during the 121-day period beginning 60 days before the ex-dividend date and ending 60 days after the ex-dividend date. Since some covered calls affect the holding period of the stock, however, it is possible that the tax treatment of dividends might be affected.

Tax treatment of covered calls

According to Taxes and Investing, the money received from selling a covered call is not included in income at the time the call is sold. Income or loss is recognized when the call is closed either by expiring worthless, by being closed with a closing purchase transaction, or by being assigned.

If a call expires worthless, the net cash received at the time of sale is considered a short-term capital gain regardless of the length of time that the short call position was open.

If a covered call is closed with a closing purchase transaction, the net capital gain or loss is considered short term regardless of the length of time that the short call position was open.

If a covered call is assigned, the strike price plus the premium received becomes the sale price of the stock in determining gain or loss. The resulting gain or loss depends upon the holding period and the basis of the underlying stock. If the stock delivered has a holding period greater than one year, the gain or loss would be long term.

Qualified covered calls

The information used to calculate the actual dollar amount is useful for other reasons as well. This information is needed to draw a profit-loss diagram. It is also necessary to calculate important aspects of a covered call position such as the maximum profit potential, the maximum risk potential, and the breakeven point at expiration.

Tax straddle rules are intended to prevent taxpayers from deducting losses before offsetting gains have been recognized. Although tax straddle rules are simple in theory, they are complex in practice because they can apply in unexpected situations and cause adverse tax effects. Fortunately, tax straddle rules do not apply to "qualified covered calls."

A qualified covered call is a covered call with more than 30 days to expiration at the time it is written and a strike price that is not "deep in the money." The definition of "deep in the money" varies by the stock price and by the time to expiration of the sold call.

Possible impact on taxable holding period of the stock

According to Taxes and Investing (page 23), "Writing an at-the-money or an out-of-the-money qualified covered call allows the holding period of the underlying stock to continue. However, an in-the-money qualified covered call suspends the holding period of the stock during the time of the option’s existence.

"Further, any loss with respect to an in-the-money qualified covered call is treated as a long-term capital loss, if at the time the loss is realized, the gain on the sale of the underlying stock would be treated as a long-term capital gain.

"Additionally, when a covered call is disposed of at a loss in one tax year and the stock is sold for a gain in the subsequent tax year, the stock must be held at least 30 days from the date of the disposition of the call in order to avoid application of the loss deferral rule…"

Let's look at an example:

Tax treatment:

• The investor is not entitled to the 15% rate on the dividend, because the stock was not held for 61 days during the required 121-day period.
• The stock was deemed to be held from September 9 to October 13 (34 days) and from November 14 to December 2 (17 days) for a total of 51 days.
• The period from October 13 to November 14 is not included in the holding period because of the in-the-money covered call.

Note: Writing an at-the-money or out-of-the-money covered call allows the holding period of the stock to continue. In the example above, had a 42.50-strike call or a 45-strike call been written with the stock price at $41, then the investor would have met the holding period requirement to be eligible for the lower tax rate of qualified dividends.

Covered calls that are NOT qualified

Covered calls that do not meet the definition of a qualified covered call generally are subject to the tax straddle rules, which are intended to prevent taxpayers from deducting losses before offsetting gains have been recognized. Positions are considered to be "offsetting" if they "substantially diminish" the risk of loss on another position.

If a multiple-part position is subject to the tax straddle rules, the consequences include the following:

• If a non-qualified covered call is sold against a stock position that was held less than one year, then the holding period for that stock is terminated.
• If both the stock and covered call are closed at the same time, then the net capital gain or loss is treated as short term.
• If the call is closed first, then a new holding period for the stock begins on the day that the covered call is closed.
• No current deduction for losses to the extent of the unrealized gain at the end of the taxable year.

Assignment of covered calls and holding period of stock

Assignment of covered calls results in the sale of the underlying stock. To calculate the appropriate tax, an investor needs to know the purchase price, the holding period, and the sale price. For tax purposes, when at-the-money or out-of-the-money qualified covered calls are assigned, the sale price of the stock is equal to the strike price of the call plus the net premium received for selling the call.

The sale of an at-the-money or out-of-the-money covered call does not affect the holding period of the underlying stock. However, the sale of an in-the-money qualified covered call suspends the holding period. Let's look at 2 examples.

Example 1:

Tax treatment: The stock sale is treated as long term, because the option was a qualified covered call when it was sold.

Example 2:

Tax treatment:

• The stock sale is treated as short term, because the option was an in-the-money qualified covered call.
• As a result, the holding period of the stock for tax purposes was from January 2 to November 16, which is less than one year.
• The in-the-money qualified covered call suspended the holding period of the stock.

Covered calls, stock holding periods, and qualified dividends

Dividends paid by the stock may also be a benefit of the covered call strategy, and some dividends qualify for favorable tax treatment if a stock is held for 61 days during the 121-day period beginning 60 days before the ex-dividend date and ending 60 days after the ex-dividend date, and the holding period must be satisfied for each dividend payment. "Days held" are calculated from the date the stock is sold, and they do not have to be continuous. The tax rate for "qualified dividends" is 15% for most tax filers, but can rise to 20% for filers in the higher taxable income ranges.

Example:

Tax treatment:

• The investor is not entitled to the 15% rate on the dividend, because the stock was not held for 61 days during the required 121-day period.
• The stock was deemed to be held from September 9 to October 13 (34 days) and from November 14 to December 2 (17 days) for a total of 51 days.
• The period from October 13 to November 14 is not included in the holding period because of the in-the-money covered call.

Note: Writing an at-the-money or out-of-the-money covered call allows the holding period of the stock to continue. In the example above, had a 42.50-strike call or a 45-strike call been written with the stock price at $41, then the investor would have met the holding period requirement to be eligible for the lower tax rate of qualified dividends.

Key takeaways

Investors who use covered calls should seek professional tax advice to make sure they are in compliance with current rules.

Profits and losses from covered calls are considered capital gains.

Qualified covered calls generally have more than 30 days to expiration and are either out-of-the-money, at-the-money, or in-the-money by no more than one strike price. However, special rules apply to longer-dated options (options with more than 12 months to expiration).

In-the-money qualified covered calls suspend the holding period of the stock that has been held for less than one year while the call is open, and non-qualified covered calls terminate the holding period of such stock (the holding period starts over when the non-qualified covered call is closed).

The tax treatment of dividends may also be affected by covered calls.