Taxing the Wheel

It is about to be October, and that means we are getting closer to tax season. In the last two months of the year, it is time to start thinking about how we will handle our taxes. For some of you, this will be the first time you have capital gains tax to pay. It pays to know where you will be hit with taxes, and how hard the IRS's punches will land.  

This post will describe the most common Theta Gang strategy, The Wheel, and how it is affected by taxes. We will also talk about going long calls and puts. Be sure to consult a tax advisor when determining your taxes on anything more complex. 

I have also written other posts on taxes. See these two posts for more information and for a description of tax-loss harvesting. Be sure to check these out: Taxes on Covered Calls and Tax-Loss Harvesting to Reduce Taxes.

Taxes on options are absurdly complex, and even actual tax professionals have a hard time with the more exotic strategies. Different online sources will also differ in their information, with some sources providing incorrect information.  

By and large, anticipate paying taxes on your positions when you gain, and writing off taxes when you lose. Since we are not billionaires, we cannot avoid paying taxes. The biggest effect options have on taxes is determining if our stock positions will be charged as short-term or long-term.

The different possible outcomes from an options trade have a big effect on taxes. This section will describe long and short options.

Long Calls

Expired Worthless: The call buyer lost his investment, so he will write-off the loss from his short-term tax if he held less than a year or long-term tax if he held more than a year.

Closed Out: The call buyer will pay short or long-term tax depending on how long the position was open.

Exercised: The call buyer adds the premium to the strike price; this becomes the buyer's basis, and he will only pay tax after he sells the stock later. He will pay tax based on that adjusted basis. The holding period begins the day after the shares hit his account. 

Short Calls (including covered calls)

Expired Worthless: The call seller will always pay short-term capital gains tax even if it expired more than a year after he sold it.

Closed out: The call seller will pay short-term tax regardless of how long it was open.

Assigned: The call seller adds the premium to the strike price; this becomes the effective sale price of the stock. He will pay tax based on this adjusted sale price. He will pay long-term capital gains tax if he held the underlying shares for more than a year, or short-term tax if he held the shares for less than a year. Important Note: If someone sells a covered call with an ITM strike price, the holding period on the stock will stop accruing toward the 1-year necessary for long-term tax. If the covered call was ATM or OTM when he sold it, the holding period continues until assignment and the shares can reach that 1-year mark. 

Long Puts

Expired Worthless: The put buyer lost his investment, so he will write off the loss from his short-term tax if he held less than a year or long-term tax if he held more than a year.

Closed Out: The put buyer will pay short or long-term tax depending on how long the position was open.

Exercised: The put buyer deducts the price of the put from the strike price. This becomes the effective sale price of the shares, or the basis of a new short position. If exercising the put results in the trader selling shares he owns, then the trader will pay capital gains tax (or write-off loss) against this new basis based on how long he held the shares. If exercising the put results in a short position, the trader will not pay any taxes until he covers the short. Important Note: If the trader buys a ITM put, the holding period on the stock will stop accruing toward the 1-year necessary for long-term tax. If the put was ATM or OTM, the holding period continues until assignment and the shares can reach that 1-year mark. Another Note: If you bought the put on the same day you bought the shares, then the put is married to the shares. You do not pay any tax on the put regardless of what happens to it. Instead, you add the price of the put to the shares, and that becomes your new basis for when you sell shares.

Short Puts (including cash-secured puts)

Expired Worthless: The put seller will always pay short-term capital gains tax even if it expired more than a year after he sold it.

Closed out: The put seller will pay short-term tax regardless of how long it was open.

Assigned: The put seller deducts the premium from the strike. This adjusted price is the trader's new basis. The trader will not pay taxes until he sells the shares later. At that time, he will pay tax based on how long he held the shares and will use his adjusted basis.

Rolling

The IRS sees rolling as two separate transactions: 1x transaction to close the open position, and 1x transaction to open a new one. Therefore, you cannot roll your taxes as you roll the position.

This can be a good thing, because when you are rolling, it is usually to roll out of a red position. In this case, rolling allows you to lock-in a loss and offset your taxes without having to abandon the position. 

If you roll an unprofitable ITM covered call in December to the following calendar year, then you can delay having to pay taxes until April of the year after. This is because you are locking-in a loss in the current year so you can take a deduction, and holding the shares into the next year. Then, if the rolled position expires in the next year, you will owe taxes the following April when taxes are due. This can presumably delay your tax bill for up to 15 months.

Keep in mind this only applies if you are rolling a red position. If you are rolling a green position, you will of course not get a deduction in the current year and so there is no tax advantage to rolling out; you would just be starting a new position.

Implications to the Wheel

In the wheel, the trader is bouncing between short calls and short puts. In almost all situations, the trader will be realizing short-term gains and losses because any sold options that expire worthless will always be taxed as short-term gains. Any options bought-to-close will also be taxed as short-term gains.

The tax implications on assignment are more significant. If the trader is assigned on a cash-secured put, the trader will not pay tax on the option itself. Instead, the trader will deduct the premium he collected by selling the put from the strike price at which he got assigned. This will act as his new basis, and he will only pay taxes on the shares when he sells them.

If the trader then sells a covered call and gets assigned, then the trader will not pay taxes on the covered call itself. Instead, he will add the premium he collected for selling the covered call to the strike price at which his covered call was exercised. He will then pay tax on the difference between his basis and the new adjusted sale price.

When wheeling, the trader will likely get assigned several times at approximately the same strike price. The following will follow the wheel and note its tax implications:

1) Sell 1x ABC $20 cash-secured put (csp) for $1
2) Get assigned, tax basis becomes $19, no taxes due on the option
3) Sell 1x $20 covered call (cc) for $1
4) Expires worthless; pay short-term capital gains tax on expired option
5) Sell 1x $20cc for $1
6) Get assigned, effective sale price $21
7) Wheel completed: Tax basis was $19, effective sale price is $21, so pay short-term tax on $2 gain

Our trader will have paid tax on $300 of short-term gains. $100 is derived from his first covered call expiring; $200 is derived from his capital gain on shares due to his assignment basis of $29 and sale price of $31.

As the above indicates, the wheel is expensive from a tax perspective. You will rarely experience long-term capital gains tax when running the wheel. 

However, there are significant tax advantages to rolling red positions into a new calendar year, because that can allow you to take a deduction in the current tax year and delay capital gains tax for many months when the rolled position eventually expires worthless.