Clever Options Trade Can Reduce Your Cap-Gains Taxes

You need to do it by Dec. 31 to save money this tax year.
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There's a clever year-end maneuver being discussed among traders that could mean big savings at tax time. It's a series of moves, including an options trade, that transform a long-term capital loss into a short-term capital loss. A short-term loss can then be used to offset short-term gains, which are taxed at higher rates than long-term gains.

If you can pull this off, you could reduce some of your capital-gains taxes nearly in half, depending on your tax bracket. But you must do it by Dec. 31 to save money on your 1998 return.

Here's the hypothetical: You have both long-term capital gains and short-term capital gains already sitting in the bank. You also have been holding a loser security for more than 12 months.

Let's say you were to sell that losing stock and take a long-term loss. Come tax time, as you fill out your

Schedule D --

Capital Gains and Losses

, you realize that you must first net your long-term capital gains with any long-term capital losses. You must then do the same for your short-term gains and losses. Only then do you net the total of your long-term gains and losses against the total of your short-term gains and losses.

In this example, though, your long-term gain was wiped out because of the long-term loss you generated on the losing stock you sold. So your overall balance will be a short-term capital gain. That's bad because the tax on short-term gains is at your individual rate -- as much as 39.6%. Long-term capital gains are taxed at only 20%.

What you would like to do, if you could, is to change that long-term capital loss into a short-term capital loss. That short-term loss would then help you wipe out your short-term gain so you can avoid paying the big taxes on it.

Here's how to do it:

First, sell the security with the long-term capital loss. Then within 30 days, buy an option on the stock, says Robert Willens, CPA and managing director of

Lehman Brothers

. At this point, the

wash sale rule kicks in and disallows the loss. That's a good thing in this case.

But you have preserved your basis in the option, says Willens. Let's say you bought a $5 option that gives you the right to buy the underlying stock at $20. According to the rules of the wash sale, the option becomes the "replacement property," so the disallowable loss is rolled into the basis of the option. If the option is $5 and -- let's assume the disallowable loss was $10 -- your option's basis is now $15.

Your next move is to exercise that option. When you do, the basis of the option is incorporated into the basis of the stock, says Richard Shapiro, an

Ernst & Young

securities tax partner. So the basis in the new stock is now $35 (20 + 15).

Now here's what makes this trade really work: When you exercise an option, your holding period in the stock drops to zero. So when you turn around and sell the stock you received from exercise, you now will have a short-term capital loss. In our example, your loss equals $15 -- the difference between the market value of $20 and your basis of $35.

"You have used wash sale to your advantage," says Willens. There are no short-sale issues here, and because all the positions are long-term, you don't have to worry about the new straddle rules either, notes Shapiro. "It's almost too good to be true."

Granted, this involves three trades, so you're going to have to pay some serious commissions. But if you're in the highest tax bracket of 39.6%, converting your short-term gain to a long-term gain could reduce your tax burden almost in half. Your commissions might "pale in comparison to the savings on the gain," notes Willens.

"This is an unbelievable trade," he says. And the beauty of it is that there has been no law change to bring it about, notes Shapiro.

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Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.