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Chapter 5. Options as Cash Generators > Tax Ramifications of Covered Calls

Tax Ramifications of Covered Calls

Calculating returns without also figuring out the after-tax outcome is not realistic. Not only must you consider a tax liability, you also need to be aware that the tax rules can drastically affect your tax rate on capital gains. The current rules for federal taxes on option trades are more complex than for most forms of investing. For conservative investors, a crucial point to remember is that selling out-of-the-money calls is the least complicated strategy, for two reasons. First, the entire premium consists of time value. Second, the tax rules are simple as long as you restrict your trades to out-of-the-money positions so there is no effect on the calculation of short-term or long-term capital gains holding periods. However, once you sell an in-the-money call, the whole question gets much more complicated. Here is a rundown of the tax rules governing options:

  1. Rules for option buyers. If you buy options, the profit or loss can either be long-term or short-term depending on how long you own the long option. The net amount is reported on Schedule D in the year of sale. If the transaction is completed within 1 year or less, it is taxed as a short-term capital gain or loss. If the total holding period was longer than 1 year, it is treated as a long-term gain or loss.

  2. Rules for option sellers. The rules for option sellers are quite different. The payment you receive at the time of sale is not taxed at that point. The tax “event” occurs when the position is closed or canceled. If you sell an option in one year and it is closed in the next, the tax is not calculated until the latter year. A “close” involves expiration of the contract, exercise, or a closing buy transaction.


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