Qualified Covered Calls—Special Rules
The tax rules applied when you write in-the-money covered calls are exceptionally complicated. There are several rules to keep in mind to determine whether your in-the-money covered call is qualified or unqualified. With a qualified covered call, your stock does not risk losing its long-term capital gains status; if the covered call is unqualified, then treatment of stock profits changes as a consequence.
ExampleMind-Boggling Limitation: You wrote two covered calls last week.
The first call is qualified in both respects. The striking price is the first available striking price below the previous day's stock closing price; and the call is scheduled to expire longer than 30 days out.
The second call is unqualified in both respects. It is not the first available striking price below close (that would have been the striking price of 50). Also, the call is set to expire within the next 30 days.
The general rule governing in-the-money covered calls refers to time. The option must have more than 30 days until expiration. In addition, the striking price cannot be lower than the striking price immediately below the closing price of the stock on the day before you open the covered call.
The rules of qualification are more complex when the call has more than 90 days until expiration. Table below summarizes the qualification of covered calls given the stock's closing price in specific stock price ranges, and with various times until expiration.
Qualification of Covered Calls
|Previous Day's Stock Closing Price||Time until Expiration||Striking Price Limits|
|$25 or less||More than 30 days||One striking price below prior day's closing stock price (Exception: you cannot have a "qualified" covered call if striking price is lower than 85% of the stock price.)|
|$25.01 to $60||More than 30 days||One striking price below prior day's closing stock price|
|$60.01 to $150||31 -- 90 days||One striking price below prior day's closing stock price|
|$60.01 to $150||More than 90 days||Two striking prices below prior day's closing stock price (but not more than 10 points in the money)|
|Over $150||31 -- 90 days||One striking price below prior day's closing stock price|
|Over $150||More than 90 days||Two striking prices below prior day's closing stock price|
ExampleA Math Challenge: You own shares of stock in several corporations. You want to write covered calls in the money, but you want to ensure that all are qualified. One stock has current market value of $74 per share. To qualify a covered call, it must be one striking price below that level, or 70, if the call is set to expire within 31 to 90 days. If the call is set to expire beyond the 90-day limit, you can write a call two striking prices below the prior day's close, which is the 65 call. If you write any in-the-money calls other than these, they will be unqualified.
- No change for at-the-money or out-of-the-money covered calls. No effect on the tax treatment of stock will be suffered if you write calls with striking prices at or above the closing price of stock.
- No change for qualified in-the-money covered calls. As long as in-the-money calls fall within the rather limited qualification period (see Table ), no effect will be experienced on the tax treatment of stock.
- Treatment of capital gains with unqualified covered call. As a general rule, stock you own one year or more is taxed at lower long-term capital gains rates. But when you write an unqualified covered call against stock, the holding period is suspended. This means that counting up to the one-year holding period will not continue as long as the short option remains open.
ExampleComing Up Short: You have owned 100 shares of stock for 11 months. You write an unqualified covered call, and your long-term holding period is suspended. Three months later, the call is exercised and you give up your stock at a profit. Even though you owned the stock for 14 months, your gain is treated as short term. You sold an unqualified covered call, so the period required before long-term rates apply is suspended.
- Treatment of covered call losses when qualified. Any losses on qualified covered calls are treated as long-term losses when the underlying stock profits are treated as long-term capital gains.
- Treatment of stock holding period when covered calls are closed. If you sell a covered call at a loss within 30 days of the end of the tax year, you have to hold on to the stock for at least 30 days in order to have the call treated as a qualified covered call.
These rules are exceptionally complicated, and the underlying reasoning for them is puzzling. It certainly requires you to use a qualified tax expert if you do engage in writing in-the-money covered calls. Additional problems may arise when you employ rolling techniques. For example, if you write a qualified covered call today, you satisfy the rules for treatment of the stock if and when the call is exercised. But what happens if the stock's price rises and you roll forward? The replacement option may end up being unqualified, based on several factors: the current price level of the stock, proximity of the stock's price to the call's striking price, and time until expiration. You could unintentionally replace a qualified covered call with an unqualified covered call.
If you are a typical investor, you view a roll as a single transaction: One option is replaced with another. But from the tax point of view, there are two separate transactions. When you close the original short position, you create a short-term capital gain or loss. When you open the second option, you may be either qualified or unqualified in the new option because it is a separate transaction.
You may question whether it is necessary to master the special and complex tax rules governing covered call qualification. However, the problem is very narrow in focus. It is only a potential problem if you write (or roll forward to) unqualified in-the-money positions. So as long as your calls are at the money or out of the money, you are not affected.
In some situations, you may view writing in-the-money calls as advantageous. For example, you can either sell stock at a profit augmented by option profits, or take advantage of stock price changes by profiting on intrinsic value price movement. If you have large unused carryover capital losses, you may also view the disqualification of stock status as an advantage. Because your annual losses are limited to $3,000, you can use a current-year stock profit as an offset to carryover loss. In this case, you will not be concerned with the loss of long-term favorable treatment.
The Absorption Factor: You had large losses in your portfolio in the years 2000 and 2001. In the current year, you still have over $50,000 in unused carryover capital losses. It will take many years to absorb these losses at the rate of $3,000 per year. However, by selling in-the-money covered calls you create numerous short-term profits, both in calls and in stock exercised against your in-the-money short calls. You view this as one way to shelter short-term profits. Current-year gains are applied against the large carryover loss, so you have no net tax consequences this year.
The second situation is when you are investing through an individual retirement account (IRA) or other retirement plan for which current income is not taxable. In these so-called qualified retirement plans, current income is free of tax, but in future years when withdrawals begin, all income is taxed at ordinary rates. Since you do not benefit from long-term gains rates within such plans, you are free to pursue even aggressive options strategies such as deep in-the-money covered calls.