Taxation of Covered Calls

by Tim Plaehn Google

    The covered call strategy has several moving parts, all of which affect the taxes you need to pay on your profits. Understand the situations that cause you to pay more taxes than necessary, and the records that are required to file your taxes.

    The covered call strategy involves buying shares of individual stocks and selling call options against those shares. Income or profits come from money received from selling the call options, dividends earned from stocks owned and capital gains if shares are called away at a profit. Losses are realized if sold calls are purchased back at a higher price, and if stock shares are sold for a lower value than the purchase price. Profits and losses are reported on your annual income tax return.

    The premiums received from selling call options are classified as capital gains. A gain is not realized until an option expires or is bought back with an off-setting buy order. If sold call options expire worthless, the whole premium received is classified as a short-term capital gain. If call options are bought back, the transaction generates either a short-term capital gain or loss, depending on the price paid to buy the options.

    If stock dividends earned are qualified dividends, the income is taxed at a lower rate. To qualify, the shares that pay a dividend must be owned for at least 61 of the 121-day period covering 60 days on either side of the ex-dividend date. Call options sold against the stock during this period must have expiration periods longer than 30 days and out-of-the money strike prices. If your covered call trade does not meet these criteria, any dividends earned are taxed at your regular income tax rate.

    Profits from the sale of stock, including shares called away by the exercise of sold call options are classified as capital gains. Long-term gains on stock owned for more than one year are taxed at a lower rate than short-term gains, which are taxed at your regular income tax rate. Stocks sold at a loss generate short- and long-term losses and can be used to offset taxable gains. If you write/sell deep in-the-money calls on stocks you have owned for more than one year, a long-term gain turns into a higher taxed short-term gain. Selling the deep in-the-money call locks in your stock gain but results in a larger tax obligation.

    You need to keep a record of every covered call trade you make during the year with the profit or loss outcome. Track both the call options sold and stock shares bought and sold. Report the result of every trade on Form 8949 and include the form with your tax return. Also keep track of whether dividends earned classify as qualified or non-qualified. Check with your options trading broker and ask about what information the broker provides to assist with the completion of Form 8949 and the accurate calculation of the taxes due from trading.

    About the Author

    Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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