Astronauts Neil Armstrong and Buzz Aldrin probably had an easier time walking on the moon 30 years ago than today's traders have trying to figure out the tax rules surrounding their options trades.
Internal Revenue Service
has recently made one small step toward clearing the dust.
On June 28, the IRS released a ruling that allows traders to specifically identify which shares of a stock they are straddling, removing a large measure of tax risk from this common hedging maneuver.
An investor with a straddle position simultaneously holds an option to buy, or "call," a security along with an option to sell, or "put," the same security for the same price during the same period. The purpose is generally to preserve big gains in a stock. In essence, you agree to sacrifice any further rise in the straddled shares' value in exchange for limiting your loss if the shares decline in value.
Until now, if a trader bought, say, 100 shares of a security at different prices and decided to straddle 25 of them, the IRS would decide which of the 100 shares were straddled, based on criteria that were never made clear. This seemingly random selection could hamper a trader's purposeful hedging tactics. For example, the IRS could decide the least-appreciated shares were straddled rather than the most-appreciated.
"So this ruling is the first of its kind," says Robert Willens, a managing director and strategic tax guru at
in New York.
This ruling comes in response to a February 1998 request from a taxpayer who asked to be allowed to specifically identify his straddled shares. Specifics of his case haven't been released, but here's the general situation he faced, according to Willens:
The taxpayer was long a stock. For the purposes of this explanation, let's say it was 100 shares. First, he decided to enter a collar position with 25 of them. A collar involves buying an out-of-the-money put and selling an out-of-the-money call against a long stock position. This is a type of straddle that allows the investor to take some additional profits if the stock rises in exchange for accepting some losses if the stock falls. (For more on collars, see an
Options Forum on the topic.)
Then he pledged 25 more shares as security for a margin loan. That means he borrowed against those 25 shares. As a result of the loan, he incurred
margin interest . Typically, if you have margin interest, you can get a deduction for that interest as an investment expense up to the amount of investment income. But that interest deduction is disallowed for stock that's part of a straddle.
"If you're in a straddle, you must capitalize the cost of the asset," says Jim Calvin, an investment management tax partner at
Deloitte & Touche
in Boston and editor-in-chief of the
Journal of Taxation of Investments
. In simple terms, that means you must add any carrying costs or interest charges to your original cost basis.
The taxpayer realized he would receive more benefit from taking the interest as a deduction rather than capitalizing those extra costs, so he needed to know which lots the IRS was going to deem part of the straddle. Specifically, he did not want the IRS claiming that the collateralized lot was part of the straddle. So he asked to be allowed to identify the purpose of specific lots.
The IRS granted his wish "in the absence of regulations" to the contrary, says Willens.
Though the taxpayer in this case was concerned about the taxability of his margin interest expense, there are other tax implications of straddles. For example, if the position is short-term, the holding period for determining the tax rate for capital gains is terminated for shares in a straddle. And any realized losses incurred on one side of a straddle (say, the stock) cannot be used if there are unrecognized gains on the offsetting side (say, the option). So taxpayers' previous inability to specify shares involved in the straddle was a major handicap.
"This is the first formal statement that seems to suggest that you can isolate your exposure rather than being at risk on your entire position," says Richard Shapiro, an
Ernst & Young
securities tax partner in New York.
So how do you put this ruling to work in your own portfolio?
Just like you specifically identify shares for capital-gains purposes when you are selling stocks or mutual funds, you must go through the same process with shares involved in your straddles.
"Send a letter to your broker saying these are the shares you want matched up with the options," suggests Willens. Then your broker should send back confirmation that you can keep in your records.
"But this must be done the day the collar
or straddle is established to make it work," says Shapiro.
He also suggests putting the straddled shares in a separate sub-account, maintained by your broker. That will further prove that those shares are meant to be hedged.
However small this IRS ruling may seem, it's a giant leap for the options world.