QQQ Options Trading In Gray Area of Tax Law

The IRS has yet to rule on how gains and losses will be taxed.
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The

Nasdaq 100

tracking stock

(QQQ) - Get Report

has proven a hit with options traders. But whether they know it or not, traders of QQQ options are blazing new territory, tax-wise.

The

Internal Revenue Service

has yet to figure out how to tax gains and losses from QQQ options trading. That leaves traders in the dark about how much, if any, of their gains will get favorable long-term rates.

Rules for taxing options on a stock or on a broad-based index, like the

S&P 500

, are firmly established. But the QQQ is neither. It is a unit investment trust that holds shares of companies in the

Nasdaq 100

index. The trust is designed to track closely the price and yield performance of the index.

"The problem is that you are discussing an option on a trust, not on the underlying index," says Richard Shapiro, an

Ernst & Young

securities tax partner in New York. "So the issue will depend on technical analysis of the existing law. It is by no means black and white."

It will take the IRS several months to sort things out, Shapiro says.

Interest in an IRS ruling is high. "The underlying trust gained $1 billion in assets in the first few months and the options have attracted similar interest," says Mike Shokouhi, a spokesman for the

Nasdaq-Amex Stock Exchange

. Total open positions on the QQQ have averaged 3,000 contracts a day since its debut in early March. "For a new product, that's huge," says Shokouhi.

Until the IRS clears things up, traders of QQQ options won't know whether their gains and losses will be taxed as equity options or as non-equity options.

Gains and losses on trading of equity options are treated like any other capital gain or loss. If, for example, you're holding a call and you sell it, you would report the difference between the cost of the call and the amount you received for it as your capital gain or loss. Since most options contracts are held for only a few weeks, on average, the gain or loss generally is taxed at the short-term rate. (See

Publication 550

- Investment Income and Expenses

for more on calculating your gains on options.)

But nonequity options (options on stock index futures or broad-based stock indexes, such as the S&P 500 index) are subject to the 60/40 rule outlined in

Section 1256 of the tax code.

That means 60% of the gain or loss on the sale of a nonequity option is taxed at the long-term capital gains rate and the remaining 40% is taxed at the short-term rate, regardless of how long the option is held. In addition, if the trade is open at year-end, it must be marked to market, meaning the security is treated as though it was sold for its fair market value on the last business day of the tax year.

Is the Nasdaq 100 unit investment trust more like a stock or like a broad-based index? That's what the IRS needs to decide. No one knows which way the Service will rule.

Meanwhile, the same uncertainty also applies to

MidCap SPDRs

(MDY) - Get Report

, a unit investment trust that is similar to the QQQ. MidCap SPDRs track the performance of the

S&P MidCap 400

index. But options on these shares have never attracted the kind of interest that options on QQQ shares have.

The uncertainty does not apply to

Standard & Poor's Depositary Receipts

, or SPDRs,

(SPY) - Get Report

, which track the performance of the S&P 500. That's because there are no options traded on these instruments.

There's also no question about how QQQ shares themselves should be taxed. For tax purposes, investors should simply treat the shares as they would mutual fund shares, says Shapiro. The difference between the original purchase price and selling price of the shares is the amount subject to capital gains taxes, and the normal holding periods for distinguishing between long-term and short-term gains and losses apply.

But until the IRS issues some tax guidance, traders of QQQ options should keep track of their buys and sells so they can adjust their bottom lines when a decision is handed down. "It's very important for the marketplace to get an answer to this," says Shapiro.