Tax Consequences Associated With Option Strategies- Part IV
Posted by Investment Management Group on Oct 13, 2011 11:54:58 AM
In this, our fourth and final post concerning the tax consequences associated with covered call writing, we will present examples that are intended to illustrate and build upon the principles discussed in the previous posts in this series. Unless otherwise noted, the examples all are based on the fact pattern described below:
1,000 shares of Johnson & Johnson are purchased on December 23, 2010. On January 4, 2011, 10 call options are written against this long position. On February 25, 2011, the stock goes ex-dividend. The options expire March 24, 2011, and the stock is sold at a gain on December 30, 2011.
1) Assuming the call option creates a straddle, the sale of the stock yields a short-term capital gain. This is because the holding period was considered eliminated when the option was written and not considered to restart until March 24, 2011 when the options expired. The holding period therefore is deemed to be less than 1 year. If the stock had been purchased on December 23, 2009 instead of 2010, the exception would apply and the gain would be long term. The dividend, however, would not qualify for DRD or QDI treatment. The holding period for these purposes would be suspended during the time period that the straddle was in place. The result is that the stock is considered held for only 17 out of 91 days for DRD purposes and 40 out of 121 days for QDI purposes. However, if we assume that the option expired on February 24, 2011, then the dividend qualifies for both DRD (46 out of 91 days) and QDI (69 out of 121 days) treatment.
2) Assuming the call option creates a straddle that is an in the money QCC – i.e. not deep in the money. Given the fact pattern above, the gain on the sale of the stock would be short-term in that the holding period would be suspended during the period of time that the QCC is in place (81 days). Accordingly, even though the actual holding period is 373 days, the 80 day period that the call was in place is subtracted to result in a holding period of 293 days – meaning the gain is short-term. Now let us assume that the stock is sold on March 14, 2012, so that the actual holding period is 448 days. Subtracting the period the QCC was in place yields an adjusted holding period of 368 – good for long-term treatment for the realized gain. Contrast this to the treatment that a straddle position would receive. Again, assume the stock was sold on March 14, 2012. In the case of a non-qualifying call option resulting in a straddle, the holding period would be eliminated and would not restart until the option expires on March 24, 2011. Adjusted for this holding period elimination, the holding period would be considered to be 357 days resulting in a short-term gain. For DRD and QDI purposes, the analysis would be the same as described in #1 immediately above.
3) Assuming the call option is an out of the money QCC, there would be no holding period eliminations or suspensions and the fact pattern would yield a total holding period of 373 days and the resulting gain would be long-term. For DRD and QDI purposes, there would be no holding period suspension and the stock would be considered held for 91 out of 91 days for DRD purposes and 121 out of 121 days for QDI purposes.
This series of posts has addressed the basic principles involved with the tax consequences of writing call options. Other, more complicated rules related to straddles exist as well and may be the topic of future posts.