Qualified Covered Calls: Simplifying Tax Rules for US Traders [With Scenarios]

Qualified covered calls can offer attractive tax advantages, but the rules can get tricky. How are covered calls taxed? It depends on expiration dates, assignments, and stock holding periods. This guide breaks down key scenarios, helping you better understand tax implications and make smarter financial decisions for long-term success.

Note: This is not tax advice. Always consult a tax professional to ensure proper planning for qualified covered calls and dividend strategies.

Key takeaways

• Qualified covered calls are options contracts that, under the US jurisdiction, meet specific criteria for favorable tax treatment.
• Taxation rules for covered calls depend on factors like option expiration, assignment, and the stock’s holding period.
• Understanding tax rules can help investors minimize liabilities and align with long-term financial goals.

What Are Qualified Covered Calls?

Qualified covered calls are options contracts that meet specific standards to qualify for favorable tax treatment under U.S. tax regulations. These rules aim to simplify taxation for traders while offering potential financial advantages.

To be classified as a qualified covered call, the contract must meet the following criteria: 

• Expiration Date: The option must have more than 30 days remaining when written. 
• Strike Price: The strike price must not be “deep in the money,” meaning it shouldn’t be significantly below the current stock price when taking into account the time left until the option expires. 

These criteria are designed to ensure that the call option aligns with standard investment practices rather than aggressive tax strategies.

Benefits of Qualified Covered Calls 

• Tax Efficiency: They avoid complex tax scenarios like the “straddle rules,” which can create unexpected tax liabilities. 
• Reduced Risk: Combining options with stock ownership can help lower overall trading risk compared to naked options. 

How Are Covered Calls Taxed?

Before we look into the very specific case of a qualified covered call, it may be worth spending a few words on how covered calls are generally taxed in the US.

So, how are covered calls taxed? Income from selling a covered call (like one you may find on our screener for the options market) isn’t recognized immediately. Instead, it is taxed when the position closes in one of these ways: 

• Expiration: If the option expires worthless, the premium collected at the time of sale is treated as a short-term capital gain, no matter how long the position was held. 
• Assignment: If the option is exercised, the stock’s sale price is adjusted to include the premium received. Any resulting gain or loss depends on how long you’ve held the stock—long-term if over a year, short-term otherwise. 
• Closing Purchase: If you buy back the call option, the net gain or loss is short-term, regardless of holding period. 

For example, if you sell a call for $2 per share on a stock worth $50 and it expires worthless, you’ll realize a short-term gain of $200 ($2 x 100 shares). 

Tax Implications of Qualified Covered Calls

So, what happens in terms of taxes when utilizing qualified covered calls? These options offer certain tax advantages, particularly avoiding the tax straddle rules. Straddle rules can delay recognizing losses, but qualified covered calls are exempt, simplifying tax calculations.

When you write an at-the-money or out-of-the-money qualified covered call, the stock’s holding period continues to count. This is crucial for achieving long-term capital gains tax rates, which are much lower than short-term rates. On the other hand, writing an in-the-money covered call suspends the holding period for the stock during the duration of the option contract. This could jeopardize eligibility for long-term tax treatment, impacting your overall tax liability.

Example Scenario – Qualified Covered Call

Just to make this theoretical concept clearer, suppose this happens:

• August 1: An investor buys 100 shares of XYZ stock at $50. 
• September 1: The investor writes an October 48 call (in-the-money). At this point, the stock’s holding period stops. 
• October 10: The call expires, and the investor holds the stock for another 15 days. 
• October 25: The investor sells the stock. 

Under tax rules, the stock must be held for more than 61 days during a specific 121-day period around the ex-dividend date to qualify for the reduced 15% tax rate on dividends. The suspension of the holding period (September 1 to October 10) results in only 59 eligible holding days, disqualifying the stock from reduced tax rates. 

With an at-the-money or out-of-the-money covered call, your holding period remains intact, preserving eligibility for favorable tax treatment. Always consider the implications of strike price selection and holding period rules, and consult a tax professional to optimize your strategy.

Non-Qualified Covered Calls and Tax Straddle Rules

There’s also the opposite case: non-qualified covered calls. These occur when the covered call fails to meet the requirements of qualified covered calls, making them subject to tax straddle rules. Tax straddle rules aim to prevent traders from deducting losses while holding unrealized gains on related positions. 

Here’s how tax straddle rules apply to non-qualified covered calls: 

• Terminated Holding Periods: If a non-qualified covered call is written on a stock held for less than a year, the stock’s holding period stops. 
• Loss Deferral Rule: Any losses on the call or stock cannot be deducted if there’s an unrealized gain on the other position by the taxable year’s end. 
• Short-Term Gain Classification: Closing both the stock and covered call simultaneously results in short-term capital gain or loss, regardless of the stock holding period. 

Example Scenario – Non-Qualified Covered Call

Once again, a quick example can help us clarify the concepts mentioned above. Let’s say this happens:

• August 1: An investor buys 100 shares of XYZ stock at $50. 
• September 1: The investor writes a November call with a strike price of $55 (non-qualified). 
• November 30: Stock is sold along with the covered call. 

Since the call is non-qualified, the stock’s holding period stops on September 1. Even if held for four months total, the stock does not qualify as long-term. Furthermore, if the covered call creates a loss, deduction is disallowed until all unrealized gains on the stock are settled.

Non-qualified covered calls introduce added tax complexity. Understanding when straddle rules apply is crucial, as these rules can impact how gains and losses are recognized. Always evaluate your strategy carefully with professional guidance. 

Assignment of Covered Calls and Stock Holding Periods

Assignment is an event that should also be taken into account, as it has tax implications. This time, we will give you two examples to clarify the matter, but first, here’s how it works. When a covered call is assigned, the stock is sold at a price equal to the option’s strike price plus the premium earned. The tax treatment of the sale depends on whether the call was at-the-money, out-of-the-money, or in-the-money, as this impacts the stock’s holding period.

Let us share a couple of examples to clarify the way assignment works in this case:

Qualified Covered Calls and Qualified Dividends

As a last point, you should know a couple of things concerning qualified covered calls on companies paying dividends. When dividends are “qualified,” they can be taxed at a lower rate, but this depends on the stock’s holding period. To qualify, the stock must be held for 61 days within a 121-day window starting 60 days before the ex-dividend date. This holding period can be interrupted by the type of covered call you write. 

• At-the-Money or Out-of-the-Money Calls: These allow the stock’s holding period to continue, making it easier to qualify for the favorable dividend tax rate. 
• In-the-Money Calls: These pause the stock’s holding period during the life of the option, potentially disqualifying dividends as “qualified.” 

Example Scenario – Qualified Covered Call and Dividend

Here is a simple example of a qualified covered call tax treatment in case of a dividend-paying company. Suppose this happens:

• July 1: Buy 100 shares of XYZ at $50. 
• August 5: Write an October 47 call (in-the-money). 
• September 10: Close the call. 
• September 12: Ex-dividend date. 
• September 30: Sell the stock. 

Since the holding period is paused from August 5 to September 10, the investor only holds the stock for 55 of the required 61 days during the 121-day window. This means the dividend is not eligible for the lower tax rate. 

Note: This is not tax advice. Always consult a tax professional to ensure proper planning for qualified covered calls and dividend strategies.