An individual taxpayer buys a stock and three years later is sitting on a large unrealized capital gain. Can the taxpayer hedge the position without creating a taxable event? Consider two specific cases:
1) The taxpayer "shorts" the same stock that is owned in a long position, and keeps both the short and long positions for two years.
2) The taxpayer sells a deep in the money covered call against the same stock that is owned, and keeps both the short call and long stock positions for two years.
Do either of those examples of hedging create a taxable event?
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Rich Carreiro
You used to be able to do that with no tax effects (it was called "shorting against the box"). However, some time ago (10 years?) the rules were changed and in most cases shorting against the box is treated as a sale for tax purposes. (And in the cases where it's not, you're not allowed to keep the short open for more than 60 days).
If the call is deep enough then it will be considered a constructive sale or other taxable event.
See IRS Pub 550.
-- Rich Carreiro snipped-for-privacy@rlcarr.com
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W
IRS Pub 550 is a big, complex, somewhat internally inconsistent document. I tried to read the relevant sections on qualified cover calls, straddles, and constructive sales, but the interactions between all of these things really require some kind of decision tree to do it accurately. I can see the IRS never sleeps unless they make everyone's life unbearable, and this document is one of their greatest hits IMHO.
What I want to know is whether I can sell a covered call against a stock position that has been held for less than one year:
1) without creating a constructive sale and incurring short term capital gains
2) without stopping and without resetting the clock on the holding period, for building a long term capital gain
One web site suggested that if a) I make sure to not get the call too deep in the money (following the guidelines in Pub 550 to make the call a qualified call option) and 2) I make sure to hold the option for at least 30 days, then I would avoid 1) and 2). Are there exceptions to that? If the call option becomes much deeper in the money during the period I hold it for
30+days, does this affect the situation?
I do understand that there are separate rules for determining price of qualified covered call if you want to protect a dividend as a qualified dividend. More complexity. More randomness. Whatever. Assume that is not my situation.
Is it correct that if I close out the covered call at a loss that I cannot take that loss until I sell the stock? When I sell the stock, will the losses on any covered calls adjust my cost basis on the stock, or will it be an ordinary loss taken separately from the capital gain?
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Steve Pope
Yes, and the former. Assuming you intentionally created a hedged position, and otherwise follow P550, nothing is closed until you close out the last position. If you sold to close, the basis is calculated from adding (or subtracting) the opening and all intermediate positions. The holding period... probably starts at the most recent sub-position you entered. If a position is acted upon you by the counterparty calling or putting, that does not reset the start of holding period.
(This is from memory and so I may have some of it wrong.)
Steve
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