Tuesday, June 21, 2011

Avoiding Capital Gains Tax - Part II

Let’s return to our article of December 7, 2010 on preserving a gain position in a stock. In that article we talked about buying a put on P&G stock.

P&G closed yesterday at $64.50. Let’s say I am looking at selling a call on P&G for January, 2012, with a strike price at $60. This means that – in January, 2012, someone can require me to sell P&G for $60 a share. For this they will pay me a premium of $3.55. Remembering that options trade in lots of 100, that means that I will receive $355 (before commissions) by selling this call.

Let’s back up. A call means that the buyer of the option can buy the seller’s stock. The buyer pays the seller a premium. In our example, the premium of $355 gives the buyer the right to buy my stock for $60 share. The total price to me is $63.55 a share. Yesterday it traded at $64.50. I am preserving all but a dollar a share of my gain through all of 2011.

The downside? If the stock runs up in price, then I will be leaving profit on the table. The buyer of the call will almost surely exercise the option and keep the profit for himself/herself. That is the reason for buying a call, after all. As a seller, I am making a contrary bet – the price will not run up.

But I may have other reasons. I may be locking in my profit. If I am happy with my profit at $63.55, and happy to receive another year’s worth of dividends, then I may sell the call to lock-in that profit. Perhaps I am guaranteeing my cash flow, such as for a child beginning college in 2012. Perhaps I am minimizing my taxes, if 2011 will be a banner year but I do not expect 2012 to repeat.

The premium of $355 is not taxable to me right away. If I wind up selling the stock, then the premium will be reported as an increase to my selling price for the stock ($60 plus $3.55). If the option lapses, I will have $355 of short-term capital gain in 2012. If I close the position – say by buying a January, 2012 call – then the difference between $355 and what I paid for the new call will be short-term capital gain or loss to me.

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