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Also, about #1, I don't think the options will reduce your basis. Not a tax expert, but I think since you paid more than $25, you'd actually have a loss if they were called, while the option itself gets taxed as a short-term capital gain. Somebody correct me if I'm wrong, please!

You want to look at IRS Pub 550, Investment Income & Expenses. The discussion of options starts on page 57, and there's a nice table on page 58 that sets out the most common situations a beginner will face. For the covered calls:

1) If the calls expire worthless, the amount you received from selling the calls is a short term capital gain. There is no change to the basis of the underlying stock. The sale of the calls is reported on Schedule D like a short sale, using "expired" for the purchase price.

2) If you buy the calls back before expiry, you have a short term gain or loss depending on whether you spend less or more to buy them back than you received for selling them. This is reported like a short sale on Schedule D. Again, the basis of the underlying stock is unchanged.

3) If the calls are exercised, you add the amount received from the calls to the amount received for the stock. This makes your capital gain from the sale of the stock greater than it would have been if you had just sold the stock at the strike price, but technically has no impact on the basis of the stock. (You get the same capital gains answer as you would if you had reduced the basis instead of increasing the proceeds, but the rules say to increase the proceeds.) The capital gain or loss is short term or long term depending on the holding period of the underlying stock.

Many people speak of reducing their basis by selling calls. This is at best sloppy communications (using an tax term to express a way of looking at investment returns) and at worst mistaken. There is no situation where writing a call affects the basis of the underlying stock for U.S. income tax purposes.

If you contemplate selling covered calls that are in the money, you need to look at the straddle rules in Pub 550. I have always avoided transactions that are subject to the straddle rules, so I don't know them in detail. I do know that I need to look at them before I sell a covered call with a strike price lower than the price the shares are trading at.

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