Tax Tips to Remember with Options

04/04/2012 6:30 am EST

Focus: MARKETS

James Fink

Editor, Jim Fink's Options for Income and Stocks to Watch

Options are great investment vehicles and are gaining popularity even among non-traditional options mavens, so it's best to understand the tax implications that newcomers may not be familiar with, advises Jim Fink of Personal Finance.

The risk of selling a covered call—besides losing out on stock appreciation above the strike price—is that the call option may be exercised and you will be required to sell the stock at the strike price. In turn, this may incur a significant tax liability if the stock is in a taxable account and your cost basis in the stock is low.

Consequently, covered calls on stocks that you have owned for a long time (and which have significantly appreciated) work best in a tax-deferred retirement account.

Your covered call can (1) expire worthless; (2) be bought back prior to expiration; or (3) exercised.

At expiration, any call option whereby the stock price is above the call option’s strike price (i.e., “in the money”) by at least one cent will be automatically exercised, which means you must sell your stock at the strike price to the call option owner.

If your covered call expires worthless (“out of the money”), you keep the entire premium and it is a short-term capital gain regardless of holding period.

If you buy back a call option before the call option holder exercises, you will have either a gain or loss, depending on whether the buyback price is above or below the premium received when you initially sold the call. As is the case with expiring options, the gain or loss from a “buy to close” transaction is always short-term, regardless of the holding period.

Take note: The income you receive from a covered call is not recognized as a short-term gain by the IRS until the date the option expires worthless or you engage in a closing transaction (i.e., buying it back).

So, if you sold a covered call for $200 on December 15 but the call didn’t expire until January 2012—and there was no early exercise of the call in 2011—the income from the covered call would be taxable in the 2012 tax year, not the 2011 tax year, even though you received the income in 2011.

If the underlying stock gets called away via exercise, you subtract the initial call premium from your stock’s cost basis and pay tax on the difference between your stock’s adjusted cost basis and the strike price at which the stock was sold.

In the case of exercise, the capital gain or loss on the entire transaction will be considered the same as the holding period of the underlying stock. Only in the case of option exercise on a stock held more than one year can the income received from selling a covered call be considered long-term capital gain.

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