Using Options to Avoid the Tax-Loss Wash

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.