While any decision about taxes and the IRS should involve a professional CPA, there are some basic rules that apply to everyone. This basic information about investing and realized capital gains is important for every investor to know. Whether they use Systematic Covered Writing or not, the rules are the rules! Consider the following points:
· The sale of a stock position is reported to the IRS on form 1099 by every brokerage firm or financial institution.
· Prior to 2011, it was every investor's responsibility to provide the IRS with the cost (cost basis) of the stock that was sold.
· If any investor purchases shares of stock on more than one occasion, and all purchases had been held in a portfolio for more than thirty (30) days, then the investor could choose which purchase to use as the cost basis for stock that was sold. IMPORTANT: When the stock is sold, the lot is assumed to be the first purchase, or FIFO. The only other stipulation is that the same stock cannot be re-purchased for thirty days after the sale.
· From 2011 on, not only are the proceeds from stock sales reported to the IRS, but also the cost basis for the stock. Most firms allow clients to specify a general guideline for allocating various multiple stock purchases to corresponding sales. For example. Instead of FIFO, one could elect to use a minimum tax (MINTAX) allocation.
· Prior to 2011, neither the sale nor the purchase of option contracts was reported to the IRS on form 1099. It was each investor's responsibility to report both the proceeds and the cost basis of closed option positions. (From January 2011 forward, all option activity is also reported to the IRS by the brokerage firm.)
There are three ways an option position can be closed.
o The option can expire. If an option contract is sold and the option expires, then the cost basis for the option is zero. The premium received from the sale is a realized capital gain.
o The option can be exercised. When an option contract is exercised the option no longer exists, its cost basis becomes zero. The premium received from the sale is a realized capital gain.
o If a closing transaction takes place, the difference between the cost to buy the option and the proceeds from its sale are a realized capital gain (or loss).
· Any gain realized from the sale of stock held less than a year in a portfolio is taxed at the same rate as the investor's regular income (also known as 'earned income'). The gains are referred to as short-term gains.
· Any gain realized from the sale of stock held more than a year in a portfolio is taxed at the capital gains tax rate, which for many investors happens to be less than their earned income rate. These gains are referred to as long-term gains. For SysCW purposes, this only applies to uncovered positions, which generally are not part of the process.
· During a year when there is a net realized capital loss (see below), the individual realizing the loss is allowed to deduct up to $3000 of the capital loss from their regular income. The benefit to the taxpayer is they would then save the income tax on $3000 of their regular income. If the income tax rate was 20%, the deduction would result in a $600.00 savings (20% of $3000 = $600).
SysCW NOTE – While a stock holding is used as part of a covered call position, that stock is not earning time towards counting as a ‘long-term’ capital gains holding. In other words, a typical covered call non-qualified account; any capital gains would be taxed at the earned income rate for the tax payer. Stock would need to be held for a year ‘uncovered’ for gains to be considered long-term.
If you would care to read in detail about the above issues, here is a link to the IRS website that should meet your needs. (You will need to use your browser Back Page feature to return)
Before moving on to a discussion about 'creating realized losses' there is a need to define a few terms:
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Equity - An equity within the realms of Systematic Covered Writing will either be a stock or it will be an option written against a stock, both are considered equities.
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Realized Capital Gain - When an equity is sold and the proceeds from that sale exceed the cost of the equity then there is a realized capital gain. The 'equity' in Systematic Covered Writing can be either a stock or an option.
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Cost - The amount paid for an equity including all fees and commissions. 'Cost basis' is another expression used to describe the cost and so is 'the basis'. These three words or expressions all mean the total amount paid to purchase the equity.
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Realized Capital Loss - When an equity is sold and the proceeds from the sale are less than the cost of the equity then there is a realized capital loss. Repeating, the 'equity' in Systematic Covered Writing can be either a stock or an option. There needs to be both a buy and a sell in order for an equity to have a realized gain or loss.
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Proceeds - The net amount received when an equity is sold. 'Net' means including all fees and commissions.
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Closed Position - Occurs when shares or contracts are purchased and then sold at a later date, or if the sale happens first, as is the case with a covered call, the option would be purchased at a later date to close the position. Buy Position + Sell Position = Closed Position. The order of the transactions does not matter.
With this information in mind, one of the goals of a Systematic Covered Writing (SysCW) portfolio is to attempt to end each year with at least a $3000 realized capital loss. Losses are systematically 'created' throughout the year without really 'losing' any money. The objective is to periodically use the SysCW Tax Deferment Strategy (TDS) to create positions where, if the option is exercised, a loss can be 'created'. Strategies involving tax issues should always be confirmed by a qualified CPA or other professional. Rules and interpretations change yearly, your professional tax advisor is the best source for current information.
