by Robert Rapier, Investing Daily
Investing Daily Article of the Week
The objective of most investors is to maximize returns at an acceptable risk level. But it’s easy to make mistakes with taxes that can add up over time. Last week I nearly made one myself, and I thought it would be a good example to share for this article.
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Violating the Wash Rule
My “near mistake” started with an actual mistake. I accidentally violated the wash sale rule.
I trade a lot of stocks, and last year I bought one back that I had sold at a loss. The problem is that I bought it back within 30 days of the sale. That transaction was triggered as a wash sale.
The wash sale rule prohibits a taxpayer from claiming a loss on the sale of a security and then buying a “substantially identical” security within 30 days of the sale. When a wash sale occurs, the loss is added to the cost basis of the new, “substantially identical” investment you purchased.
Although harvesting tax losses is an important tool in helping minimize your taxes each year, you definitely want to avoid the wash sale.
Trade the Option or Trade the Stock?
Now for my near mistake. The company in question was the retailer Big Lots (NYSE: BIG). The company has been through ups and downs over the past couple of years. After hitting a high above $63 in January 2018, the company fell below $13 in March of this year. Since then, it has recovered back above $50.
I first bought Big Lots in March 2018 for $45 a share. I had actually sold a covered call at the same time, so my cost basis was somewhat lower. As the share price declined and the calls expired, I sold new calls.
At one point shares rallied and they were called away at a loss. Again, because of the covered calls I was selling, the loss was less than I might have otherwise taken.
But during the course of my stock screening over the next month, it popped up again on my radar and it didn’t register that it had been less than a month that I sold it. So I bought it again and the transaction was flagged “Wash sale.”
The share price steadily declined, but between the nice dividend the company paid and the calls I was selling, I managed to minimize my losses. But then shares began to reverse earlier this year. That’s when I nearly made the mistake.
In April of this year, and with shares trading at about $20, I sold a covered call with a strike price of $30 and expiration in January 2021. But the share price soared. Last week it reached $50, which meant there was $20 of appreciation I would not receive if the option had been at expiration. (This is the only real risk of selling covered calls.)
So last week I found myself in the position of having a paper loss on the call, but with the share price finally back above the price I had paid back in 2018. Normally, I never take a loss when I sell a call because I allow it to expire. If shares are called away, then I accept it, but I keep 100% of the call premium.
However, this time was different. If I let the call go until expiration, I would have had a short-term gain on the sale of the call. But my BIG shares would have been called away at $30, lower than the price I had paid for the shares.
I realized in this case I needed to modify my normal strategy for tax purposes. Instead of paying a 24% short-term capital gain on the call I sold, I bought the call back and took a short-term loss. That will help offset other short-term gains. Then I sold the shares, which I have now held for more than two years. My shares of BIG were sold at a profit and a long-term capital gain rate of 15%.
I have often delayed selling a position to ensure that my holding period was at least a year to benefit from the lower long-term rate. But I think this is the first time I have encountered this specific situation in which it made more sense to take a short-term loss on an option to benefit from the long-term gain on a stock.
It was a reminder that you always need to consider the tax implications of your trades.
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