Steven Smith

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Using Options to Avoid the Tax-Loss Wash

Steven Smith

After a three-year absence, the stock market will once again be welcomed to the Thanksgiving table and rejoin the list of things for which we are grateful. In the aftermath of the feast, many people who are sitting on healthy gains will have time to ponder profit-taking and protection plans, and the possibility of selling off a few losers for tax-loss purposes.

Many investors, however, are rightfully reluctant to sell holdings simply for tax purposes. Of course, if you think the stock is a dog and has little chance of recovery, then you should by all means dump it. But if you still believe in a company's long-term prospects, you may want to retain ownership.

(Before we go any further, let me remind you that you should always consult a qualified tax expert before engaging in any transactions. Tax laws, especially those related to investing, are notoriously complex and constantly changing -- each situation is handled differently. I'm not a tax expert, but one thing I can state without equivocation is this: Don't try to use options as a means to avoid taxes. If you owe taxes, you will pay -- one way or another.

Double-Dipping

Congress created the "wash sale" rule to prevent taxpayers from selling stocks at a loss and then reacquiring "substantially identical" securities within a 30-day period before or after that loss (and thereby claiming a tax loss). A 1988 amendment defined options and various combination positions as "substantially identical" to the underlying stock, and they are thus subject to wash sale regulations. That means a wash sale exists when you close an option position at a loss, or if you establish a replacement position within the 61 days surrounding the realized loss. This also means you can't just sell out a stock and then buy it back the next day, nor can you purchase calls or sell deep-in-the-money puts.

One way for investors to avoid a wash sale and still realize a loss is through the process known as doubling up. Michael Schwartz, Oppenheimer's chief option strategist, explains that to take advantage of the strategy, an investor would simply "buy an additional and equal amount of shares of the stock one would like to sell for a loss, wait at least 31 days, then sell out the shares that were originally owned," to book the loss.

Turkey Day in More Than One Way

The last day to double up this year is Nov. 28 -- the day after Thanksgiving. You must then wait 31 days, or until Dec. 29, until you sell out the original shares to realize the tax loss. If you don't double up but simply sell the shares, you would need to wait another 31 days, or until Jan. 29, to avoid having any repurchase classified as a wash sale. Understand that doubling up also doubles your exposure to both profits and losses during the 31-day holding period.

Schwartz suggests using a long-term call or LEAPs options instead of buying more of the underlying shares. The main advantage of using options is that they not only reduce the risk during the holding period but are less costly in absolute dollars. "Options are cheaper in that, aside from currently being priced at historically low levels, their leverage allows you to double up with significantly less capital than purchasing actual stock," said Schwartz.

He points out that the loss of options' value due to time decay is less acute in longer-dated options and isn't a real issue until less than three months remains in the life of the contract. "Analysts who set price targets often allow 12 to 18 months to give stocks time to reach the goals," Schwartz said, "so why shouldn't call-buyers use those time frames?" That's another reason he prefers LEAPs over shorter-term options.

Few and Far Between

Of course, one drawback of buying calls, as opposed to actual shares, is that for companies paying a dividend, an option owner, unlike a shareholder, doesn't receive that payment. But Schwartz points out that some of this can be offset by collecting interest on the proceeds of the sale of the stock.

But the dividend variable doesn't look like it will create widespread concern. I ran a company screen with these basic criteria: a market cap greater than $500 million, a stock price above $20, an annual dividend of at least 2% and a stock decline of 10% or more over the last year. Only 15 names appeared:

Search your own holdings during the next week to determine which stocks you'd like to jettison, which you want to hold, and those few in which it may pay to double up.