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Author: zman49 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121100  
Subject: Re: LEAP Options, Taxes, and an exit strategy Date: 9/7/2000 5:47 PM
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Colin,

Greetings.

Questions:
1. If I hold a LEAP call option for more than 1 year, does that get long term capital gains treatment when I sell?


If you do not establish an offsetting position during the time you hold the LEAPS call it will be taxed as a long term capital gain/loss, assuming you hold it over 1 year before selling it.

2. If I hold a call option for less than a year (say 7 months) then I exercise the option and hold the underlying stock for another 7 months. When I sell that stock, does that get long term capital gains treatment?

No. The holding period for the stock begins the day you exercise the option.

3. If I purchase a call LEAP, which appreciates, for 6 months. Then (to protect my investment) I sell short the underlying stock, and keep my short position for an additional 7 months. (I liquidate the short position by exercising the LEAP .. after having held for 13 months, which covers the short position which I have held for 7 months) What is my tax treatment in this case?

At the time you short the underlying stock you will esstablish what the IRS calls a "straddle" for tax purposes. (Any offsetting positions which include options are considered straddles by the IRS.) Your holding period for all positions that are part of a straddle (unless you had held the position for over a year when you established the straddle) is reset when the straddle ends. In the situation you described, both the short stock position would be the taxable position, the cost basis of the position would be the sum of the amounts you paid for the option and the stock (the strike price), and the holding period would be zero days.

Here is the scenario:

In the second week in January 2000, I purchase LEAP options on company XYZ with expiration in January 2001. The total time associated with this option is 1 year and 1 week.
During the course of the year, the underlying stock (XYZ) appreciates well beyond the strike price of my option. Now I am nervous. I want to lock in some profit on my options, but I would also like to realize long term capital gains treatment. How do I do this?
I have thought of two possibilities:
1. buy put options at a strike price above the call option strike price. That would insure me a gain of at least putStrike - callStrike.
2. sell short the underlying stock, and cover in the week before expiration (after holding the call for more than 1 year)(see question 3 above)

From a tax perspective, should I do: 1, 2, or other?


Either of the two possibilities would create an IRS straddle and invoke all the rules associated with straddles. As mentioned before, one of these rules would make and gains/losses short term.

The straddle rules were designed to require that the investment must remain at risk for a full year in order to get long term capital gain status the investment must remain at risk for a full year. They are, as far as I can tell, quite effective in meeting that goal. By hedging you could put off the tax bite from this year to next, but only if you maintain some risk.

If you were to eliminate essentailly all risk, you would create what the IRS calls a "constructive sale" and you would be liable for the taxes in the year the constructive sale occurred, even though you had not actually closed you position yet.

There is a lot more information in IRS Publication 550, available at

http://ftp.fedworld.gov/pub/irs-pdf/p550.pdf

You can also get some information on constructive sales by clicking on "Tax Strategies FAQ Index" at the top of this page.

Good Luck,
Z
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