Options: Several Strategies Can Make Trades More Tax-Efficient
By MOHAMMED HADI
DOW JONES NEWSWIRES
January 7, 2006; Page B4
For investors who made tax efficiency a resolution for this year (and who didn't?), options might offer some help.
That's because, in some instances, these derivatives are taxed differently than stocks or exchange-traded funds.
For example, it is well known that short-sellers are taxed at short-term capital gains rates -- which can be as high as 35% -- no matter how long they hold on to a short position. But another way to speculate that a stock is going to fall is to buy a put option, and puts are taxed "normally," said Robert Gordon, president of New York-based brokerage Twenty-First Securities Corp.
By "normally," he means that, if the put is long-term, or is sold more than a year later, then the tax rate is 15%.
It is simple enough, but this rule applies only to a naked put -- that is, one which isn't used to hedge an existing stock position -- explained Richard Shapiro, financial-services tax partner at Ernst & Young who literally wrote the book on investing and taxes. The book is called "Taxes and Investing" and is available free 888options.com on the Options Industry Council's Web site.
For those looking to take a short-term position on the broad market, options on indexes can offer a better tax structure than options on an exchange-traded fund.
That's because options on ETFs are taxed like options on stocks and, if you sell them within a year of the purchase date, you have to pay short-term capital gains.
Options on indexes, though, get a special tax treatment. Regardless of how little time has passed, profits are taxed with a ratio -- 60% of them are taxed as long-term gains and 40% as short-term gains, said Michael Schwartz, chief options strategist at Oppenheimer & Co.
Assuming short-term gains are taxed at 35%, that means the tax rate on gains made on an index option is only 23%. An investor making a three-month bet on the Standard & Poor's 500 Index is better off -- from a tax perspective -- using options on the index itself, rather than options on the S&P Depositary Receipts, or Spyder, ETF to deploy his view.
There's some wiggle room, though. Although both Schwartz and Gordon tout this benefit to index options, Ernst & Young's Shapiro noted the Internal Revenue Service hasn't actually ruled that options on ETFs can't get the same 60/40 treatment, which means your accountant could choose to apply this rule to them. "The issue is not clear," he said.
But, Shapiro cautioned, if an investor chooses to treat ETF options with the 60/40 rule, the rule must be applied consistently. "The one thing not to do is cherry pick tax treatments from investment to investment," he noted.
Not all index options get this 60/40 benefit. The index has to meet requirements that define them as "broad", not "narrow." For example, the S&P 500 is a broad index, while Philadelphia Stock Exchange Keefe, Bruyette & Woods Bank Index is narrow. |
