It's earnings season again. How is your darling stock going to fare?

If you have a position that might slip a bit because of disappointing earnings but don't want to sell and take a capital-gains tax hit this year, consider "collaring" your gains. With a collar, you sell a call option and buy a put option on your underlying stock so you can protect downside risk and still can participate in some of the stock's appreciation.

But if you're not careful, the tax implications can choke you.

In options lingo, a collar is a type of straddle position that involves calls -- option contracts that give you the right to buy a certain shares at a specified price (the strike price) up to the expiration date -- and puts -- option contracts that give you the right to sell stock at a certain strike price up to an expiration date. To create a straddle, you buy calls and puts with the same strike price and expiration dates.

For that straddle to be a collar, you need to hold the underlying stock. Then you "collar" that stock by buying an out-of-the-money put option and selling an out-of-the-money call option against that long stock position. This combination of puts and calls can limit, but not eliminate, any risk you face if your shares drop.

When you buy an out-of-the-money put, you buy an option with a strike price lower than the underlying stock's market price. That gives you the right to sell your long shares at a price somewhere below the current market value.

When you sell an out-of-the-money call, you sell an option with a strike price higher than the stock's current market price. Doing this obligates you to sell your shares when the current market value is greater than or equal to the call's strike. By executing these trades, you get downside protection with the puts and defray their cost by selling the calls, but you do limit the upside at least for the life of the options.

Why not just buy the put to limit your downside and leave your upside alone? Because it costs money to buy a put. "So to finance the purchase, you sell a call," says Thad Shelley, senior vice president and restricted stock and hedging specialist at Bessemer Trust in Washington, D.C.

But how do you define "out-of-the-money"? The Internal Revenue Service offers no guidance. But as long as the strike prices of your options make up at least a 20% range around the stock, that's out-of-the-money, says Steve Rosenthal, a financial-products tax partner at KPMG in Washington, D.C. So if the stock is at $100 and you buy a put with a $90 strike and sell a call with a $110 strike, you're OK. This 20% yardstick is just a best guess that the pros use, until we hear from the IRS.

It's important that your options are out-of-the-money. If you buy or sell in-the-money options, you will have to tend to the constructive sale rules, and they're ugly. At this point, a collar is not subject to the constructive sale rules, although we again are waiting for confirmation from the IRS.

Taxes Can Straddle Your Collar

"The biggest danger in entering collar is that it creates a straddle against stock position," says Rosenthal. And the tax rules for straddles can be onerous.

You face two big concerns with the tax rules for straddles, says Rande Spiegelman, a senior manager in KPMG's investment advisory-services group in San Francisco. First, you lose your holding period on a short-term stock; second, you cannot deduct your losses if one side of your positions is still open.

Under the rules, the holding period on your long shares may be halted or lost. The holding period is the length of time you've held the stock, and it helps determine whether your gain or loss is short-term or long-term for tax purposes. If you've held the position for 12 months or less, you have a short-term holding period. If you sold a short-term security at gain, you'd owe ordinary income tax on it. That could be as high as 39.6%. On the flip side, if you've held the stock for more than 12 months, you're long-term. If you sell your long-term stock at a gain, you only will owe the 20% long-term capital gains tax.

But when you enter a straddle, in this case, a collar, your holding period gets adjusted. According to the rules, if you collar a long-term stock, your holding period will be suspended until you get rid of the collar. So if you collar a stock you've held for 15 months, the holding period remains 15 months until you get rid of the collar. But since you're long-term already, you don't really care.

If you collar a short-term stock, your holding period reverts to zero. And the holding-period clock doesn't begin ticking until you get rid of the options. "No question. This trade is rarely considered on short-term security," says Shelley.

If that's not bad enough, the loss deferral rules kick in, too. Think of your position as having two sides -- the stock and the options. The loss deferral rules say that any realized losses incurred on one side of a straddle (say, the option) cannot be used if there are unrecognized gains on the offsetting side (say, the stock).


Spiegelman helped out with a worse-case example.

Let's assume you bought your stock at $50 and it's now trading at $100. You want to defer your gain, so you write a call with a $110 strike and receive $5 for it, your premium. You also buy a put with a $90 strike for $1.

Now the stock has zoomed to $120. The guy who bought your call wants his stock because he now has the right to buy it at $110. But you don't want to sell your underlying shares because then you'll owe big capital gains tax this year. Remember, the idea was to defer your gain. So you go out in the market and buy new shares at $120. The buyer gives you $110. You have a $5 loss (110 - 120 + 5).

The rules say that you can't use that loss until you sell your underlying long position, says Spiegelman. So adjust your original basis for your loss. Since you originally paid $50 for the share, just add the $5 loss to it. Your new basis is now $55. (We'll assume the put is still open, so there are no tax implications yet.)

Granted, no collar is a lock. But if planned properly, it could be a good way to defer your capital gains hit, and protect your stock from a summer slump. Be sure to check out Publication 550 -- Investment Income and Expenses for more details on these rules.

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TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.