Options and the Wash-Sale Rule

With all joy comes a little sorrow. So it is during the holiday season, when all good investors should start planning what they'll give to the toughest name on the list, the Internal Revenue Service.

Like Santa, the IRS keeps track of your behavior. The more you receive, the more it expects to get. One way to reduce taxes on profits taken on winners is to realize losses by selling holdings that are down.

But with the stock market just recently regaining its fervor and roaring to a new 52-week high, many investors are understandably reluctant to sell holdings simply for tax purposes. If you think the stock is a dog and has little chance of recovery, then by all means dump it. If, however, you still believe in a company's long-term prospects, there is a strategy that allows you to both retain ownership and realize a tax loss in 2004.

Before we go any further, remember that you should always consult a qualified tax expert before making any transactions. Tax laws, especially those related to investing, are notoriously complex and constantly changing. Each situation is handled differently. I'm not a tax expert, but one thing I can say without equivocation is this: Don't try to use options to avoid taxes. If you owe taxes, you will pay -- one way or another.

Time to Do the Wash

Congress created the "wash sale" rule to prevent taxpayers from selling stocks at a loss and then reacquiring "substantially identical" securities within a 30-day period before or after that loss (and thereby claiming a tax loss). A 1988 amendment defined options and various combination positions as "substantially identical" to the underlying stock; thus, they are subject to wash-sale regulations.

That means a wash sale exists when you close an option position at a loss, or if you establish a replacement position within the 61 days surrounding the realized loss. This also means you can't just sell out a stock and then buy it back the next day. Nor can you purchase calls or sell deep-in-the-money puts.

One way for investors to avoid a wash sale and still realize a loss is through the process known as doubling up. This involves buying an additional or equal amount of shares of the stock one would like to sell for a loss, waiting at least 31 days, then selling out the shares that were originally owned to book the loss.

The last day to double up this year is tomorrow, Nov. 30. You must then wait 31 days, or until Dec. 31, before selling out the original shares to realize the tax loss. If you don't double up but simply sell the shares, you would need to wait another 31 days, or until Jan. 31, to avoid having any repurchase classified as a wash sale. Understand that doubling up also doubles your exposure to both profits and losses during the 31-day holding period.

One way of reducing the risk is to purchase call options instead of buying more underlying shares. Options are not only less expensive in absolute dollar terms, but with implied volatilities at historically low levels, they are cheap on a relative basis. Options allow you to double up with significantly less capital than purchasing actual stock. But thanks to their leverage, they can offer nearly identical upside potential.

Going Long

If you decide to double up, I suggest using longer-dated, or LEAP, options. First you need to make sure the option doesn't expire within the 60-day window or you may inadvertently trigger a wash sale at expiration. Second, because time decay is less acute in longer-dated options, price erosion shouldn't become a real issue until less than three months remain in the life of the contract. Finally, you should double up only if you believe in a company's long-term prospects, so it makes sense to allow 12 to 18 months for the stock to regain its ground.

Of course, one drawback of buying calls rather than actual shares is that for companies paying a dividend, an option owner, unlike a shareholder, doesn't receive that payment.

Some widely held names that are down more than 10% for the year but are still poised for year-over-year earnings growth and have relatively inexpensive options include Clear Channel ( CCU), Forest Labs ( FRX) and Colgate-Palmolive ( CL).

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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