Capital gains tax strategies and traded options
When call options are purchased and subsequently exercised, the cost of the options is added to the cost base of the purchased shares. If the call options are not exercised, the cost is deducted in the tax year in which the options expire. If the call options are closed out by selling them, the proceeds are included in income, and the original cost is written off, in the tax year in which the options are closed out.
When put options are purchased, the cost is written off in the year in which the options expire, are exercised, or are closed out by selling them. For taxpayers who record gains and losses from options as capital gains or losses , the timing is a little trickier for options which have been sold. The following table shows the timing of the recording of gains and losses on options that have been sold or purchased.
Event Timing of proceeds reported for tax purposes Tax treatment when options are sold: To revise the capital gains from the previous year, a T1Adj would have to be filed. See our article on changing your tax return after it has been filed. Of course, if the prior year tax return has not been filed when the options are exercised, the prior year return can be done omitting the gain, eliminating the need for a later revision.
Usually, the taxpayer would benefit from filing the T1Adj. The only problem is that the Income Tax Act requires the options proceeds to either be added to the proceeds from the sale of shares call option , or deducted from the cost basis of shares purchased put option when the option is exercised.
This applies even if the proceeds were taxed in a previous year, and no T1Adj was filed to reverse this. Therefore, double taxation will occur if the T1Adj is not filed.
During the year you sell 3 Put options of the same underlying and they expire out of the money. Based on the above table, each transaction should be treated as capital gain in the year sold. What if on the 4th option sold of the same underlying, you end up with the underlying shares?
Clearly you reduce the cost of the shares assigned by the value of the premium received on the 4th sale. BUT can you further reduce the cost of the shares by including the first 3 premiums collected if the shares are sold in the same year? Each sale of put options is a separate transaction, and not related to the next sale of put options. Under those circumstances, you must sell the stock yourself. Another strategy that would provide you the protection you need, while buying you the time you need would be a collar.
A collar, however, can cost you money because the collar involves the trading of two options, and therefore costs you more in commissions. We have discussed the collar strategy in your Home Study Guide. When applying the collar to this situation, make sure you choose an expiration month that is beyond the one year time period from the purchase date of your stock.
Before you make a final decision on selling a deep in-the-money call to avoid short term capital gains tax, make sure you check out the collar and compare its suitability against the call sale strategy to see which is better for you.
As you can see from our example above, the sale of a deep in-the-money call can buy enough time and protection for you to artificially extend your stock position with minimal risk.
If employed properly, the Tax Deferral Strategy can save you many thousands of dollars in saved taxes. Be sure to talk to your broker and your accountant about this strategy before employing it. Tax laws change regularly, as you can see, and you should check with an expert to make sure this strategy is still viable. It is important to consult with a professional accountant or tax attorney before employing any of these strategies to see which is currently acceptable with the IRS.
In reality, the IRS is stating that the stock was effectively sold on the date the call was sold and not on the expiration date of the call. If the IRS will not let us use in-the-money options or at-the-money options for tax deferral, then we must find a way to use out-of-the money options to lock in the stock price for the period of time necessary to meet the long term gain requirement, as in the case of the collar strategy.
As you recall, the collar combines the purchase of an out-of-the-money put, with the sale of an out-of-the money call. The proceeds of the call sale will be used to off set the cost of the put and thus, the total outlay of capital will be minimal.