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Married Put and Stock "Tax Traps"
Married Put and Stock is a tax strategy designed to avoid the unintended tax consequence of a put purchase derived from the general rules governing short sales. We all know that tax laws are very complex and full of tax "traps" for the unwary but, I think you'll agree, the married put and stock tax trap is a beaut! If you are a short-term trader, none of this will matter much to you. However, if you are an investor whose objective is long-term capital gain treatment: Pay strict attention! Situation 1: Suppose you are in the fortunate position of holding stock that qualifies for long-term capital gain treatment. You did your research well, you took the risk, you sweated out the holding period, and now you think that it may be a good time to cash in. Let's further suppose that it's near year end. If you cash in now, you will owe tax for this year. Since it's near the end of the year, you could push the tax into next year by postponing the sale until after year end. Smart move, tax-wise. The only problem is: What if the stock falls while you're waiting for the calendar to go by? Suddenly it hits you! What if you bought a put option that doesn't expire until after this year is over??? Terrific! That way, if the stock drops, you just locked in todays' price and, if the stock continues to climb, you get to make an even bigger gain next year! Either way, the tax is pushed into next years' business all at the same time! Brilliant! All this, mind you, with the blessing of those very nice people over at the IRS. Absolutely brilliant! You are sooooooo smart! You're tax accountant would be so proud! Situation 2: Same as above, except the stock has not yet been held long enough to qualify for long-term treatment. Now what happens if you buy a protective put option as before? Does it change anything? You better believe it does! Can you still postpone the tax into the next year? Yes, you can. Can the stock be held long enough to mature into a long term capital gain? No, it can't. Why is long-term treatment allowed in the 1st instance but not the 2nd? Excellent question. I'm glad you asked. And the answer is (drum-roll, please): In the 1st instance, the stock held was already a long-term hold. Nothing you do can ever change that. In the 2nd instance, however, the stock held was only short-term when the protective put option was purchased. BANG! That sound you just heard was the married put and stock "tax trap" slamming shut on you! You walked right into it. Wham! The moment you bought that protective put option, you just wiped out the holding period on your stock. Just flat out "erased" it. All that sweating out the holding period hoping for a long-term capital gain all for naught. And, as if that weren't bad enough, for as long as you own that put option, not only does the holding period go back to zero, it stays stuck on zero! The clock won't start running again until you get rid of it - either through sale, exercise, or expiration. Didn't I tell you that this married put and stock "tax trap" was a beaut? Nice going, genius. Why are they doing this? Obviously, too many traders, in the past, were converting short term gain into long term with no risk. It's not supposed to be that easy. Fortunately, there is an exception (isn't there always?). It's called the Married Put and Stock rule. If the put and the stock it is intended to protect are bought on the same day and indicated on the trade confirmation to be a hedge, the put and the stock are considered to be "married" and the normal tax rules for stock holding periods apply. The combined cost of the put and stock constitute the tax basis. When this rule was originally created, the holding period for long-term treatment was over six months (that is to say, six months-plus-a-day). A "six month" option was always written as six months-plus-ten-days in order to qualify for long-term treatment, if desired. This allowed an investor to buy stock, protect it, and still have a chance of realizing a long-term gain. This was possible with options with more than six months of life remaining. If, instead, the stock declined, the put option could be exercised while the holding period was still less than six months resulting in short-term loss treatment of the position. See the tax advantages of the married put and stock strategy? Heads long-term gain, tails short-term loss. At this writing, however, long-term is over one year. The only options that last that long are called LEAPS. In the married put and stock strategy, can the put utilized be of shorter duration? Yes, it can. Can you write-off the put cost after it expires like a normal put purchase? No, you can't. It's "married", remember? It's part of the combined tax basis. Can you replace the expired put with a new put? Only if you're willing to wipe out the holding period of the stock. That's the married put and stock "tax trap", remember? You can only "marry" a put to a stock once. Is there a situation where you might be willing to wipe out the holding period on purpose? Yes, there is. You might be willing to "re-start" the holding period "clock" on a stock in order to prevent a short-term unrealized loss from going long-term. If that would improve your situation, make the married put and stock "tax trap" work to your advantage. How? Simply buy a put and immediately resell it. Presto! You just avoided long-term loss. And you thought tax law was dull. Are you kidding? It's practically pornographic! It reminds me of a scene in the motion picture, The Godfather, where Don Corleone (Marlon Brando) is telling his son, Michael (Al Pacino), "Always remember, one lawyer with a briefcase can steal more money than an army of thugs with all their guns!" As you can see, the married put and stock tax strategy can be extremely useful as long as you avoid the unintended tax consequences. As always, consult with your tax professional for an opinion, before entering into any complex transaction.
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