Using Options to Invest Tax-Efficiently

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SPY – With 2019 drawing towards a close it’s time investors need to look at their portfolios for rebalancing and determining asset allocation.

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With 2019 drawing towards a close it’s time investors need to look at their portfolios for rebalancing and determining asset allocation.  While it should never be the driver of investment decisions one needs to always keep an eye on tax implications as they can have a significant impact on the final total returns.   

Typically, at year-end you’ll see some profit taking in winners to reduce exposure in names that have become a much larger percentage of the portfolio through price appreciation.  This is often accompanied by the selling of losers; sometimes simply because the investment was deemed ‘wrong” but often driven by tax decisions.  

This is known as tax loss selling, in which the losses from one investment can be used to offset the gains in another.   This may be especially important this year as so many stocks have such substantial gains.  

In tax loss selling occurs when an investors notice they are in a losing position at the end of a tax year, they close that position at or near the end of the year. Second, the sale allows them to take a loss that they can legally claim on their tax returns as a reduction of their earnings for that year. In this way the pay a smaller amount of taxes. Third, after the new year begins, the investor will look to purchase the security at or below the price they sold previously.

But the wash sale rule  states that in order for the loss to be allowed one cannot purchase a “substantially identical stock or security” within 30 days of the sale. So, if you want to take a loss in 2019 and be able to repurchase the shares on January 2st the last day to do so and avoid the wash sale would December 1st

This rule makes some people reluctant to sell out losers in which they have strong and long held conviction on fear they will be missing a turning point.  

Think about the end of 2018 with stocks tumbling sharply through November and December. If people bailed on the market into the Christmas low it meant you couldn’t repurchase the same security until the third week of January. 

This means whether owned an index based ETF like the SPY, which surged 12% in January –that’s half of the 2019 gains thus far—or individual stocks such as Microsoft (MSFT) or even commodity based securities like Gold (GLD) you missed a big chunk of this year’s gains.  

This year, for example, the cannabis sector has taken a major blow, with stocks like Canopy (CGC) and Village Farms (VFF) down over 60% for the year to date.  But many people are still believers in the sector and might fear missing a rebound in the beginning of 2020 which could be sparked by passage of marijuana reform laws. 

Options may provide a way to bridge that 30-day divide and work around the “substantially identical” clause to keep some upside exposure while benefiting from the tax loss selling.  But before I go any further let me state a huge caveat; tax laws surrounding wash sales can be extremely complicated and one should consult with a financial planner and certified accountant, of which I am neither, before engaging in any transactions.  

Similar But Not the Same  

There is still some debate over what constitutes “substantially identical” but most of it boils down to does the new position essentially track the risk and profit/loss profile of the old position.  A basic stock replacement  in which stock is sold and long term in-the-money calls are purchased would probably be disallowed.  Buying short term out of the calls or a spread which have a much lower delta and a limited profit and are usually deemed sufficiently different to pass muster. 

A safer route would be to make use of the plethora of exchange traded funds that have become available since the wash sale rule came into effect.   

Constructive Sale

Finally let’s look at ways to time shift a holding.  For a long time people wanting to maintain upside exposure but eliminate short-term risk, and thereby shift the higher income tax rate down to the lower long term capital gains rate, was fairly simple; initiate a fresh short sale position, use futures or buy deep-in-the-money puts or sell deep-in-the-money calls.  But in 1997 Congress introduced the constructive sale rule  which disallowed such offsetting transactions.   Note, all the rules apply equally positions that were initiated as shorts in terms of closing out for a profit or loss.   

But there are some there some exceptions that involve holding periods or employing more complicated options strategies that are legitimate on the theory that sufficient risk still exists as not to constitute a constructive sale.  

These might include employing an options collar strategy, that is the simultaneous purchase of an out-of-the money put and the sale of an out-of-the money call.  This creates a band in which additional profits and losses still can be achieved/incurred but are well defined and limited.   But again, check with an appropriate advisor as the rules can be dependent on the risk retained which involves not only the dollar amount, percentage range and the volatility.  Some of these issues are still being debated in Congress.  

In the meantime it always pays to explore the ways options can help reduce risk and boost returns. 

 


SPY shares were trading at $311.35 per share on Friday afternoon, up $1.80 (+0.58%). Year-to-date, SPY has gained 26.32%, versus a % rise in the benchmark S&P 500 index during the same period.


About the Author: Steve Smith


Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...


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