The “Hidden” Tax Benefits Of This Income-Trading Strategy Are Often Overlooked…
There are a number of great benefits to the covered call options strategy. This approach to trading allows us to create reliable income from our stock positions while reducing the amount of risk that traditional investors face.
In addition to generating solid returns, there are some very attractive tax advantages available to covered call traders. We’ll get into the details shortly, but first, a quick review of how covered calls work.
To generate income with covered calls, ideally we want to buy (or already own) a quality stocks that is fundamentally strong. It can be treading water or showing positive price action — but the important thing is that we don’t want to do this with stocks that are falling rapidly. Using the income to offset losses is a dangerous proposition.
For every 100-share lot of this stock, we then we sell one call contract.
A call option gives the owner the right but not the obligation to buy 100 shares of stock at a specific price within a defined time period. By selling these call contracts, we are giving someone else the right to buy 100 shares of stock from us at a specific price. We get paid to sell this right, which is how we generate income in the form of a premium.
On the expiration date, if our stock is trading above the designated price (called a strike price) we must fulfill the obligation and sell our stock. But if the stock is trading below the strike price, we get to keep our stock. We also get to keep the payment we received for selling the option contract.
Tax Treatment Of Covered Call Options
As a general rule, the payment you receive from the option contract can be classified as a reduction in the cost basis of the stock. This is important — especially when it comes to taxes.
For instance, if you bought a stock at $50 and sold March $55 calls against the position for $3 per share, your net cost for the position is $47. If the stock remains below $55 and the calls expire, you should not have to pay taxes on the $300 of income ($3 per share x 100 shares) that you received by selling the call contracts.
Instead, you now own shares of the stock with a lower cost basis.
Some traders continue to sell calls against their stock positions. This continually creates income in their portfolio while slowly reducing the cost basis for their stock.
When the stock is eventually sold, the total amount of gains will be reported as taxable gains. But there is a definite advantage in deferring the tax liability until the position reaches “long-term gain” status, or simply into the next tax reporting period.
The very best tax advantage for covered call trades is when you can hold the original stock position throughout a full year. This gives you the opportunity to sell four, five, or even six different contracts against your position. It’s up to you.
But if you sell calls with a high enough strike price so that you are not obligated to actually sell our shares, then things get interesting. This means you can continue to generate income all year long and have this income taxed at the long-term rate.
Remember, short-term capital gains are taxed as ordinary income according to federal income tax brackets. For many investors, this can represent a significant savings, potentially as much as 25% to 35% of the potential tax liability depending on your tax bracket. This also makes a significant difference when you look at the long-term return rate of your taxable investment account.
The key here is making sure that you are able to hold on to your original stock through an entire 12-month period rather than selling with a gain before the 12 months are up.
There are also instances where it makes sense to use the covered call approach to defer a tax liability into the next year. Even if the trade is ultimately recorded as a short-term gain, deferring the trade into the next tax year can give you the use of all your capital for an additional 12 months. This is in contrast to paying the short-term tax gain in the current year and having a smaller capital base for generating income in the following year.
A Creative Approach…
Keep in mind, it never makes sense to stick with a poor trade simply for tax reasons. And we are not tax professionals. But there are some tricks you can use with strong covered call options trades to extend the life of the position and potentially hold for long-term gains.
There are times when a covered call position trades higher than the strike price. That means you are going to be obligated to sell your stock when the call contract expires.
But let’s say the stock is still trading in a healthy pattern. And there are call contracts expiring further down the road that are attractively priced… You could elect to buy more stock at the higher price, and then sell additional calls against the new stock.
Technically speaking, you’re simply setting up a new covered call position with the same stock. But you may not realize that when the original calls expire, you can choose which block of stock to exercise them against.
So in this case, you could sell the second lot of stock that you purchased at a higher price and keep your original shares. In all likelihood, you will recognize an accounting loss on this second block (which is good for tax purposes). But you’re still holding your original position with a much lower cost basis.
Using this strategy allows you to keep your block of stock with the lowest cost basis. It also defers your tax liability until you have held it long enough to qualify for long-term gains — or it can serve to defer liability into the next calendar year.
Of course you should speak with your accountant about your individual situation before implementing these tax deferral strategies in your account. There may be extenuating circumstances that would be important to know before using this options strategy for tax purposes.
The bottom line is that covered call options can generate tremendous returns and are potentially much more tax-friendly than most other trading strategies.
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