Collaring Your Year-End Profits With Options

Keep the Collar Loose

As part of its 1997 tax act, Congress included a provision regarding a "Constructive Sale of Appreciated Property," which was defined as "having made a sale at the moment you enter into a short sale of the same or substantially identical property."

The "substantially" part would include options, and in essence, Congress sought to prevent people from removing the risk from existing positions while maintaining and benefiting from said holdings. (Here's a useful article on constructive sale rules.)

Depending on the volatility of the underlying stock, the separation between the strikes of the put and call options, and the length of time remaining until expiration, certain collars may not be considered a constructive sale, which would allow you to secure a profit but defer the recognition of taxable gains.

These positions will be addressed by the Internal Revenue Service and scrutinized by the Securities and Exchange Commission on a case-by-case basis, but "a good rule of thumb is that the position should still be exposed to a 5% loss over the next three months," said Tom Byron, a financial consultant with New York-based Blay Asset Management. Due to the collar's basic structure, this also means that one should be able to enjoy a 5% gain over the same time period.

In addition, if either the long put or short call moves into the money, it may trigger a short-term loss or gain that might fall under tax-straddle rules (an investor with a capital gain takes an option position creating an artificial offsetting loss in the current tax year and postponing a gain from the position until the next tax year) and not be allowed or recognized as an offset. Stricter rules are currently being added regarding tax straddle positions and the treatment of selling deep-in the-money calls and puts to defer taxes.

The Senate Finance Committee recently passed a provision that would even eliminate the "qualified covered calls" (calls that are not short term and not written in the money) exemption from tax-straddle rules. For more information on the rules governing options and taxes, see the "Taxes & Investing" section of the Options Clearing Corp. Web site.