How are covered calls taxed?
The IRS wants to make sure investors do not use deep-in-the-money options when writing covered calls since that would allow investors to possibly:
- Mismatch gains and losses in different tax years
- Substantially reduce the risk of holding positions
As a result, the IRS developed the Qualified Covered Call (QCC) rules. Generally, if an investor is seeking to grow the underlying security position to long-term capital gain status, while preserving Qualified Dividend Income (QDI), they should limit their call writing activities to at-the-money and out-of-the-money options with 30 days or more until expiration. However, if an investor utilizes calls with greater than 12 months to expiration, they will have to adjust the Lowest Qualified Benchmark (LQB) by 2% per quarter.
The call premium received from a QCC will be recognized as a short-term capital gain if the option expires or the investor enters into a closing transaction. However, if the option is assigned, the premium will be taxed in accordance with the underlying stock position.
How are protective puts taxed?
If your position in the stock is not eligible for long-term capital gains treatment and you purchase a protective put, your holding period is eliminated. Unfortunately, your holding period will not restart until the put is disposed. However, a put purchase will not affect your holding period if either:
- The stock is already eligible for long-term capital gains treatment
- The put is “married” to the stock purchase
In either scenario, Qualified Dividend Income (QDI) is forfeited while the put is in place.
* Please be aware of the fact that tax laws and regulations can change and are subject to varying interpretations. Investors should consult with tax advisors for up-to-date tax advice applying to their particular investments.