How are options on the QQQ taxed?

-- Don Stroud

Don,

You have hit on a very hot topic. This issue has people guessing -- almost as much as who will win this season of

Survivor

.

Except there is a big difference. In just a few weeks, we will know who will be the last survivor. We still will not know how to treat options on the QQQ.

The

Nasdaq 100

tracking stock

(QQQ) - Get Report

was introduced in 1999 and quickly became the hottest thing in town. Through a single transaction, investors can own a piece of the tech-centric Nasdaq 100

stock portfolio. For more of the basics on the QQQ, see this previous

column.

But like many of the tax rules surrounding new securities, the

Internal Revenue Service

hasn't offered much guidance.

Why?

Here's the problem: Should options on the QQQ be taxed like regular equity options or should they be treated as options on a broad-based index?

Equity options, like an option on

Microsoft

(MSFT) - Get Report

stock, are reported on

Schedule D

-- Capital Gains and Losses

-- just like your stock or mutual fund trades. In simplest terms, the gain or loss is based on the difference between the option's purchase price and its sales price. Most gains or losses on equity options are short-term.

On the flip side, options on stock index futures or broad-based stock indices, such as the

S&P 500

index, must follow

Section 1256 of the tax code. Regulated futures contracts and foreign currency contracts fall under this section as well.

Section 1256 says that any gains or losses from the sale of these securities are subject to the 60/40 rule -- 60% of gains and losses are long-term and 40% are short-term, regardless of how long the securities are held. So even if you held the option for a month, 60% of your gain will be considered long-term and taxed at the 20% preferential long-term capital-gains rate. The remaining 40% will be taxed at your ordinary income tax rate.

These gains and losses are first reported on

Form 6781

-- Gains and Losses From Section 1256 Contracts and Straddles

. The totals then will flow up to Schedule D. Check out this previous

column for examples.

So which is it? Part of the confusion is determining whether or not the QQQ is considered a "broad-based index." Is the Nasdaq 100 as broad as the S&P 500 or the

Dow Jones Industrial Average

, which both have tracking stocks similar to the QQQ? That question remains unanswered.

Many of my sources believe that the 60/40 rule is the way to go with the QQQ options.

As a matter of fact, after speaking with someone at the IRS, Ted Tesser, trader tax specialist and author of

The Trader's Tax Solution,

says he will treat options on the QQQ as 1256 contracts until the IRS announces otherwise.

Others, like Diane Garnick, global head of exchange-traded funds research at

Merrill Lynch

, argue that "since the QQQ does not expire quarterly and they are not regulated futures contracts, they will be treated as single stocks for tax purposes." In this instance then, the QQQ would not be considered a broad-based index, so the options would be treated like regular equity options.

There is an argument for both sides, says Richard Shapiro, an

Ernst & Young

securities tax partner and author of the

Chicago Board Options Exchange's

Taxes & Investing

booklet. "But don't expect guidance any time soon."

So for this tax season, sit down with your tax preparer (or your conscience if you're a self-preparer) and do what you think makes the most logical sense.

Remember, the onus falls on you, the taxpayer, in the end. So be sure to save any documentation that will support your final decision.

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