How Covered Calls Are Taxed

Covered calls look simple on a payoff chart. The tax side is a bit more involved, and in a taxable account it can turn a good looking strategy into a mediocre one after tax. Here’s what US investors writing calls on stocks or ETFs need to know. (Funds that do it for you handle this themselves; their distributions were covered in How Dividends Are Taxed and Section 1256 and the 60/40 Rule.)

When premium is taxed

You don’t pay tax the moment you collect premium. The tax result is settled when the call position ends, which happens in one of three ways:

Note the first two: premium from calls that expire or are bought back is short-term no matter how long you’ve owned the shares. It’s taxed at your ordinary income rate.

Assignment: the premium joins the sale

That last point matters. If you hold a stock with a large unrealized gain that you never intended to sell, a covered call can force the sale, and the tax bill, in a year you didn’t choose.

Qualified covered calls

The tax code treats a stock plus a call written against it as a potential “straddle,” which can defer losses and mess with holding periods. Most ordinary covered calls escape this because they count as qualified covered calls. Broadly, a call is qualified if it:

• is traded on an exchange,
• has more than 30 days to expiration when written, and
• isn’t “deep in the money,” a limit set by IRS rules based on the stock price and the available strikes.

Out of the money calls with a month or more to run are usually fine. The trouble starts with deep in the money calls, very short calls, or calls written on shares you’ve held less than a year:

• Holding period suspended. Writing a non-qualified call (and in some cases an in the money qualified call) can pause or reset the holding period on your shares, turning what would have been a long-term gain into a short-term one.
• Losses deferred. Straddle rules can delay losses on one side of the position while gains on the other are taxed.

Your dividends can lose qualified status

To be qualified, a dividend needs more than 60 days of ownership around the ex-date, and days when your risk of loss is reduced don’t count. Writing calls that aren’t qualified covered calls can reduce your risk enough that those days are excluded. The result: dividends you expected to be taxed at 15% may be taxed at your full income rate. Sticking to out of the money qualified calls usually avoids this.

A few more points

• Wash sales can apply when you sell shares at a loss and sell puts or buy calls on the same stock within 30 days. See Tax-Loss Harvesting for Dividend Investors.
• Cash-secured puts: premium on an expired or closed put is a short-term gain. If you’re assigned, the premium reduces the cost basis of the shares you buy.
• Record keeping: brokers report option trades on Form 1099-B. A tracker that links assignments to their options, like Premium Tracker, makes year-end checks much easier.