The tax rules applied when you write in-the-money-covered calls are exceptionally complicated. There are several rules to keep in mind to determine whether your in-the-money covered call is qualified or unqualified. With a qualified covered call, your stock does not risk losing its long-term capital gains status; if the covered call is unqualified, then treatment of stock profits changes as a consequence.
Mind-Boggling Limitation: You wrote two covered calls last week.
The first one was written with a striking price of 30; the stock’s previous day’s closing price was 32. The call expires in two months. The second call was written with a striking price of 45 and the stock closed the day before at the price of 52. This call expires in three weeks.
The first call is qualified in both respects. The striking price is the first available striking price below the previous day’s stock closing price; and the call is scheduled to expire longer than 30 days out.
The second call is unqualified in both respects. It is not the first available striking price below close (that would have been the striking price of 50). Also, the call is set to expire within the next 30 days.
If you write out-of-the-money-covered calls, there is no effect on the status of stock. The following explanation applies only when your covered calls are in the money at the time the transactions are opened.
The general rule governing in-the-money covered calls refers to time. The option must have more than 30 days until expiration. In addition, the striking price cannot be lower than the striking price immediately below the closing price of the stock on the day before you open the covered call.
The rules of qualification are more complex when the call has more than 90 days until expiration. The table below summarizes the qualification of covered calls given the stock’s closing price in specific stock price ranges, and with various times until expiration.
Qualification of Covered Calls
|Previous Day’s Stock Closing Price||Time until Expiration||Striking Price Limits|
|$25 or less||More than 30 days||One striking price below prior day’s closing stock price (Exception: you cannot have a “qualified” covered call if striking price is lower than 85% of the stock price.)|
|$25.01 to $60||More than 30 days||One striking price below prior day’s closing stock price|
|$60.01 to $150||31 — 90 days||One striking price below prior day’s closing stock price|
|$60.01 to $150||More than 90 days||Two striking prices below prior day’s closing stock price (but not more than 10 points in the money)|
|Over $150||31 — 90 days||One striking price below prior day’s closing stock price|
|Over $150||More than 90 days||Two striking prices below prior day’s closing stock price|
A Math Challenge: You own shares of stock in several corporations. You want to write covered calls in the money, but you want to ensure that all are qualified. One stock has current market value of $74 per share. To qualify a covered call, it must be one striking price below that level, or 70, if the call is set to expire within 31 to 90 days. If the call is set to expire beyond the 90-day limit, you can write a call two striking prices below the prior day’s close, which is the 65 call. If you write any in-the-money calls other than these, they will be unqualified.
What happens when you write an unqualified call? The rules governing the consequences, which are also called the antistraddle rules, affect long-term capital gains qualification of stock. Following is a summary of five ways the rules work:
Coming Up Short: You have owned 100 shares of stock for 11 months. You write an unqualified covered call, and your long-term holding period is suspended. Three months later, the call is exercised and you give up your stock at a profit. Even though you owned the stock for 14 months, your gain is treated as short-term. You sold an unqualified covered call, so the period required before long-term rates apply is suspended.
These rules are exceptionally complicated, and the underlying reasoning for them is puzzling. It certainly requires you to use a qualified tax expert if you do engage in writing in-the-money covered calls. Additional problems may arise when you employ rolling techniques. For example, if you write a qualified covered call today, you satisfy the rules for the treatment of the stock if and when the call is exercised. But what happens if the stock’s price rises and you roll forward? The replacement option may end up being unqualified, based on several factors: the current price level of the stock, the proximity of the stock’s price to the call’s striking price, and time until expiration. You could unintentionally replace a qualified covered call with an unqualified covered call.
If you are a typical investor, you view a roll as a single transaction: One option is replaced with another. But from the tax point of view, there are two separate transactions. When you close the original short position, you create a short-term capital gain or loss. When you open the second option, you may be either qualified or unqualified in the new option because it is a separate transaction.
You may question whether it is necessary to master the special and complex tax rules governing covered call qualification. However, the problem is very narrow in focus. It is only a potential problem if you write (or roll forward to) unqualified in-the-money positions. So as long as your calls are at the money or out of the money, you are not affected.
In some situations, you may view writing in-the-money calls as advantageous. For example, you can either sell stock at a profit augmented by option profits, or take advantage of stock price changes by profiting on intrinsic value price movement. If you have large unused carryover capital losses, you may also view the disqualification of stock status as an advantage. Because your annual losses are limited to $3,000, you can use a current-year stock profit as an offset to carry over loss. In this case, you will not be concerned with the loss of long-term favorable treatment.
The Absorption Factor: You had large losses in your portfolio in the years 2000 and 2001. In the current year, you still have over $50,000 in unused carryover capital losses. It will take many years to absorb these losses at the rate of $3,000 per year. However, by selling in-the-money covered calls you create numerous short-term profits, both in calls and in stock exercised against your in-the-money short calls. You view this as one way to shelter short-term profits. Current-year gains are applied against the large carryover loss, so you have no net tax consequences this year.
There are two situations in which you will not be concerned about the loss of favorable long-term capital gains tax rates. The first is when you have a substantial carryover loss. Because net investment income can be offset against past-year losses, current-year capital gains, even short-term gains, are fully protected from any taxes.
The second situation is when you are investing through an individual retirement account (IRA) or other retirement plan for which current income is not taxable. In these so-called qualified retirement plans, current income is free of tax, but in future years when withdrawals begin, all income is taxed at ordinary rates. Since you do not benefit from long-term gains rates within such plans, you are free to pursue even aggressive options strategies such as deep-in-the-money covered calls.