Ask Bev: Looking at Wash Sales, Covered Calls

Understanding tax law requires the patience of a Talmudic scholar. But one aspect in particular seems to give readers a crisis of faith unsurpassed by any religious experience -- the "wash-sale" rule.

The wash-sale rule governs the purchase and sale of different lots of the same security -- it's when you buy one lot and sell another within the next 30 days, or sell one lot and buy another within 30 days. Under the rule, if the wash sale results in a capital loss, the Internal Revenue Service won't allow you to claim that loss as a deduction. Rather, you'd add the amount of the loss to your basis in the new shares. So the benefit isn't lost, only delayed. The increased basis in the new shares ensures that you'll either owe tax on less of a gain or will be able to claim a larger loss when you eventually sell those shares.

Technically, the wash sale prevents you from claiming a loss on a security if a "substantially identical" security was purchased in that 61-day window. So if you sell 100 shares of Cisco ( CSCO) at a loss but then three weeks later repurchase another 100 shares, you'll have to adjust the basis of the new shares to reflect the loss incurred in the sale, rather than being able to use it to offset gains you may have reaped in other areas of your portfolio. The "substantially identical" stipulation, though, means that it's not just buying new shares of Cisco that will trigger the wash-sale rule, but also contracts or options to buy Cisco.

In practice, the wash-sale rule has inspired more reader mail than any other subject this column has tackled. For more background, click here, here, here and here.

Beverly,

I have modest very long-term holdings in several direct dividend reinvestment programs, e.g. Johnson & Johnson (JNJ). If I buy 100 shares of JNJ today through my brokerage account, and sell it at a loss on Feb. 17, does the wash-sale rule come into play by virtue of the small dividend received and reinvested automatically in the interim?

Thanks,

Doug D.

Stocks and mutual funds that automatically reinvest your dividends can indeed trigger the wash-sale rule -- but only if you continue to hold some shares. So if you sell all 100 shares of Johnson & Johnson -- including whatever shares you received as a dividend payment -- you won't incur the wash-sale rule and will be able to claim the loss.

But if you sell only, say, 50 shares, but receive a dividend on all 100, you will run into the wash-sale rule. Any additional shares you receive as a dividend will prevent you from claiming a loss on that number of shares sold. So if you receive a dividend equal to two shares, you'll be able to claim a loss only on 48 shares. You'll adjust the basis of the two shares received as a dividend to reflect the disallowed loss.

Dear Beverly,

Scenario: Two accounts: one is self-managed; I purchased 1,000 shares of XYZ on 12/15/03. Still hold at 1/22/04. The other account is managed by a large institution. Sold 500 shares of XYZ at a loss on 12/31/03. The institution was doing some year-end "house cleaning" and did not know that 1,000 shares were purchased in the self-managed account.

Do the wash-sale rules apply here with two separately managed investment accounts?

Thanks for your help.

Shawn D.

Unfortunately, there's no clear answer for this. Typically, the IRS looks at the taxpayer's entire portfolio, not any one individual account. So even though one of your accounts is managed by an institution, it's the overall picture that concerns the IRS -- that's why you can't avoid the wash-sale rule by selling stocks at a loss in a brokerage account and repurchasing the same shares in an IRA.

You don't specify what type of account is managed by this "large institution." If it's a broker discretionary account -- wherein your broker has free reign to make buying and selling decisions without acquiring permission for each move -- that's still essentially an account under your control. And that means any tax consequences that result from your account manager's buying and selling are very likely yours and yours alone, according to Mark Luscombe, a CPA and attorney with CCH, a tax-law research firm.

If this institutionally managed account of yours were a blind trust, though, the situation could be different. A blind trust is also an account managed by a third party that has complete discretion -- but the beneficiary is not informed about the holdings of the trust. (Blind trusts are often set up by individuals -- such as politicians -- who want to avoid any perception their investments influence their behavior.) Since you seem to have been informed as to the shares that were sold in your institutionally managed account, I doubt it qualifies as a blind trust.

If it were, though, the law is unclear as to whether investing decisions made in the trust can trigger the wash-sale rule on your tax return. To be a factor in triggering the wash-sale rule, the purchase and sale must occur in accounts that are under the control of the taxpayer, Luscombe says. "It would be hard to see how a blind trust would fall into that category," Luscombe says. "But I'm not sure which way that would fall. There's definitely an argument that a blind trust is out of your control." There's an even better argument if the manager of the blind trust files a tax return for the trust, rather than it being included on the taxpayer's 1040.

The conservative advice is to hold off on claiming that loss. Admittedly, though, the timing is painful. Had you not bought the 1,000 shares, you'd be able to enjoy an immediate tax break on the 2003 loss incurred in your managed account. Now, though, the basis in your new shares will be adjusted to reflect the loss you would otherwise have been able to claim by April. You will, though, be able to indirectly claim the loss (by dint of the adjusted basis) when you do sell the remaining shares.

And if you want to do it sooner, I suggest you find a tax lawyer of your own.

Option contracts can do more than trigger the wash-sale rule -- they can also affect the holding period of the underlying stock. The next question doesn't concern the wash-sale rule; consider it a bonus, and read on for another reason to carefully evaluate your options.

Does the writing of covered calls on a stock position affect the calculation of the holding period for capital gains? I thought I read somewhere that it does, depending on the strike price of the call option used. Could you help clear this up for me?

Thanks,

Mike

Unlike many tax questions, this one has a straightforward, definitive answer -- yes.

Writing a call option means selling another individual the right to buy shares of a certain stock at a certain price by a particular date. "Covered" calls are those written by investors who currently own the stock they're writing options on; "naked" calls are those in which the writer of the option does not own the underlying stock. (That's a much riskier strategy, since if the stock rises and the buyer chooses to exercise the option, the seller must first purchase the stock and then sell it at the lower option price.)

Covered option writing will reduce the holding period on the underlying stock day for day -- and that can have a big impact on the tax consequences of any sale. If you sell shares of Microsoft ( MSFT) you bought 13 months ago, you're eligible for the 15% long-term capital gains tax rate. But if you had written covered calls that covered a total period of two months, your holding period would drop to 11 months -- and you'd owe ordinary income tax on your gain. Same goes for the losses -- the duration of your covered calls could be the difference between claiming a long-term or short-term loss when you sell the shares.

If you're buying and selling rapidly, or really hanging in there for the long haul, this probably won't matter, because you're clearly in short- or long-term territory.

The holding period isn't affected by the reason for the stock sale -- it doesn't matter whether you sell the underlying shares because the covered call option was exercised, or if the options expire and you decide to sell anyway. Nor does it matter what the strike price of the option was. All that's at issue is the total duration of time any options written covered, and subtracting that from the ultimate holding period of the stock at the time of sale.

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