Tax Consequences Associated With Option Strategies- Part I
Posted by Investment Management Group on Oct 7, 2011 11:40:05 AM
As the investment world becomes more and more complex, we here at BBD are beginning to see more and more funds being created that employ alternative investment strategies. Although, it is not a new concept by any means, some of the new funds we see employ option oriented strategies (particularly covered call writing) to enhance total returns. This post begins a four-part series that explores some of the tax consequences involved with writing covered calls against a long investment portfolio. The primary tax concerns center around rules that defer the deductibility of capital losses on “straddles”; holding period suspensions for stocks subject to written calls which can cause what might otherwise be a tax favored long-term capital gain to be treated as a short term capital gain; and limitations on the ability to characterize dividends on stocks subject to written calls as either eligible for the corporate dividends received deduction (“DRD”) or the favored tax rates afforded to qualified dividend income (“QDI”). This post will present the basics of the straddle rules.
Definition of Straddles and the Loss Deferral Rule of Sec 1092(a)
Under Internal Revenue Code (“IRC”) section 1092 and the regulations thereunder, a straddle is defined as an “offsetting position” where there is a "diminished risk of loss by holding one or more other positions with respect to substantially similar or related property.” The term diminished risk of loss is defined to include situations where the fair value of the stock and the fair value of the offsetting position (option) are reasonably expected to vary inversely. If a taxpayer holds two positions that are part of a straddle, IRC section 1092(a) provides that any loss realized from the disposition of one or more positions of the straddle are deductible in any taxable year only to the extent that the amount of such realized loss exceeds the "unrealized gain" (if any) with respect to one or more positions which were offsetting with respect to the positions sold (i.e. the unrealized appreciation inherent in the portion of the straddle still held at year end). Any excess realized loss is disallowed for tax purposes and carried to the next year with a deduction allowed upon the disposition of such offsetting positions that made up the initial straddle (i.e. - the appreciated position in the straddle).
Viewed in its most simple form, a straddle would exist if a taxpayer were to hold long stock that is appreciated for the entire year and during that year, write several call options against that stock and close all of those options at losses prior to the end of the tax year. Assuming the written call options create a straddle with the long stock (i.e. they are not “qualified covered calls”, as discussed below), the collective losses on closing the written call options would not be deductible for tax purposes to the extent that they were equal to or less than the unrealized appreciation inherent in the long stock position at the end of the year. Such losses would be suspended, and potentially deductible in the next tax year. Note that losses on the options exceeding the unrealized appreciation on the stock would be deductible in the current tax year.
This post focused primarily on the tax consequence of writing call options against long stocks. However, straddles can arise in the context of other option strategies as well. Examples of straddles also include a long stock with a purchased put or a short sale with a written put or purchased call.
The next post in our series will examine the “qualified covered call” exception to the straddle rules.