Covered Call Tax Treatment

Calculating tax on covered calls results in knowing the correct gain.

Tax treatment of covered calls affects the actual gains investors realize from these options. Sellers of covered calls have capital gains or losses that depend upon when and how the options are resolved after being sold.

Control of covered calls belongs to the buyer. The seller may repurchase the control, permit it to expire or allow the option to be exercised by the buyer. Careful sellers of covered calls may receive favorable long-term capital gains tax treatment on amounts received from selling covered calls that are exercised.

Repurchased Calls

When covered calls are repurchased, there is a taxable gain or loss comprising the difference between the price obtained from selling the calls and the cost to repurchase them. The gain or loss is short-term for conventional calls, which start trading less than nine months prior to expiration. This causes all conventional call transactions to occur within the short-term transaction period of a single year. The gain or loss is taxable in the year that the call options are repurchased.

Expired Calls

Covered calls that expire unexercised are a capital gain for the seller. The entire amount received from selling the calls comprises the gain because there is no cost to purchase. The gain for conventional call options is short-term. The gain is taxable in the year that the call option expires.

Short-Term Exercised Calls

Exercised calls require the seller to surrender the underlying stock. The covered calls are not separately taxed. Instead, the amount received for selling the stock includes the amount for selling the covered calls. The gain or loss is short-term when the underlying stock was owned for one year or less. The gain or loss is taxable in the year that the call option is exercised.

Long-Term Exercised Calls

When stock is surrendered from exercised covered calls that were sold more than one year after owning the stock, the gain on the transaction is long-term. The amount received from selling the covered calls is added to the amount received for the stock in calculating the gain.

However, if the covered calls were sold less than one year after the stock purchase, particular qualifications must be met for long-term tax treatment. If the covered calls were sold in a non-qualified transaction, the transaction is short-term--even if the stock was owned for more than one year. That's because the holding period is suspended during the time that a non-qualified covered call position exists.

Qualified Long-Term Transaction

In a qualified sale, covered calls sold prior to owning the underlying stock for more than one year are included in a long-term gain. The stock surrendered by exercise of the call option must have been owned for more than one year. There must have been more than 30 days until expiration when the covered calls were sold. In addition, the covered calls must not have been sold for a price below the "lowest qualified benchmark."

In most cases, the "lowest qualified benchmark" is the highest strike price available on the call option market that is less than the current price of the underlying stock. If the strike price is more than $50 per share and the covered call expires in more than 90 days, the lowest qualified benchmark is the second highest strike price below the share price of the underlying stock. When share price of the underlying stock is $150 or less, the strike price of the covered call option must not be more than $10 below the share price.

References

• Chicago Board Options Exchange
• Internal Revenue Service: Publication 550
• 26CFR 1.1092(c)(4)(B); "Code of Federal Regulations"; Title 26, Volume 11;
• 26CFR 1.1092(c)(4)(D); "Code of Federal Regulations"; Title 26, Volume 11;