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Consider a situation where an investor owns a stock for over a year and sells calls against it that expire in about 90 days. You can assume that this is a qualified covered call for tax purposes.

After some time, the calls are deep in the money and the investor is about to get assigned on the calls. If assigned on the calls he will have a 10K long term capital gain. If he buys the calls back he will have a 5K short term loss. If he just sells the stock he will have a 15K long term capital gain. Assuming the investor already has other short term capital gains then from a tax point of view he is better off buying back the calls and selling the stock out right.

Do I have that right? I am also assuming that since he was short the call option for less than a year the loss in the calls would be considered short term. Is that right?

Bob

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    Unless your tax rate is >100%, it is better to make money and pay tax, than lose money and save tax. – Grade 'Eh' Bacon Jul 18 '17 at 14:18
  • @D Stanley The calls were sold out of the money so the initial premium was small. Since the stock has moved up, so has the price of the calls. Hence, when if I elect to buy back the calls, it will be at a loss. – Bob Jul 18 '17 at 14:37
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Your three options are:

  1. Buy back the calls but keep the stock, taking a net 5K loss,
  2. Buy back the calls and sell the stock, for a net 10K gain, or
  3. Let the options settle, netting a 10K gain.

Options 2 and 3 are obviously identical (other than transaction costs), so if you want to keep the stock, go for option 1, otherwise, go for option 3 since you have the same effect as option 2 with no transaction costs. The loss will likely also offset some of the other short term gains you mentioned.

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    @D Stanley. Do you agree that if I buy back the calls, I have a short term capital loss. From a tax point of view, am I not better off with option 2? – Bob Jul 18 '17 at 16:26
  • Bob, do you want to hold on to the stock or not? That's your answer. – JTP - Apologise to Monica Jul 19 '17 at 16:59
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    @Bob I seem to remember a tax rule to split an exercised option into short-term/long-term gains/losses for this type of scenario, but I can't seem to find it. If that's not the case then yes I would agree that there could be a difference tax-wise. – D Stanley Jul 19 '17 at 17:07
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if you buy back the now ITM calls, then you will have a short term loss. That pair of transactions is independent, from a tax perspective, of your long position (which was being used as "collateral" in the very case that occurred).

I can see your tax situation and can see the logic of taking a short term loss to balance a short term gain. Referring to D Stanley's answer, #2 and #3 are not the same because you are paying intrinsic value in the options and the skew in #2, whereas #3 has no intrinsic value. Of course, because you can't know the future, the stock price could move higher or lower between #2 and #3.

#1 presumes the stock continues to climb.

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