30.9 Straddle Losses
Tax accounting rules generally match losses against unrealized gains in offsetting straddle positions. Straddle rules apply to commodities and to stock options used in straddle positions. Straddle positions include actively traded stock if at least one of the offsetting positions is: (1) a position on that stock or substantially similar or related property, or (2) the stock is in a corporation formed or used to take positions in personal property that offset positions taken by any shareholder. True hedging transactions are not subject to the straddle tax rules.
A call option is not treated as part of a straddle position if it is considered a qualified covered call option. A qualified covered call option is an option that a stockholder who is not a dealer grants on stock traded on a national securities exchange. Furthermore, the option must be granted more than 30 days before its expiration date and must not be “deep-in-the-money.” A “deep-in-the-money” option is an option with a strike or exercise price that is below the lowest qualified benchmark. The rules for determining these values are discussed in IRS Publication 550. A covered call option will not qualify if gain on the sale of the stock to be purchased by the option is reported in a year after the year in which the option is closed, and the stock is not held for 30 days or more after the date on which the option is closed. In such a case, the option is subject to the straddle loss deferral rules. The same loss deferment rule applies where the stock is sold at a loss, and gain on the related option held less than 30 days is reported in the next year.
Filing Tip
Loss on a qualified covered call option with a strike price less than its applicable stock price is treated as long-term capital loss if loss realized on the sale of the stock would be long term. The holding period for stock subject to the option does not include any period during which the taxpayer is the grantor of the option.
Tax rules for straddles.
The following paragraphs give a brief overview of the straddle rules, and if you have transacted straddles or are considering such transactions, we suggest that you see IRS Publication 550 and consult with an experienced tax practitioner.
Generally, a realized loss on a position that is part of a straddle is deductible on Form 6781 to the extent that it exceeds the unrecognized gains in offsetting positions as of the close of the taxable year. Any part of a loss that is not deductible is carried forward to the next year and subject to the same limitation. However, you may not deduct any loss from an identified position that was established in an identified straddle after October 21, 2004. Instead, you must increase the basis of the offsetting positions in the identified straddle that have unrecognized gain by the amount of the unallowed loss; see the Form 6781 instructions.
Filing Instruction
Straddle positions of related persons (such as a spouse or child) or controlled flow-through entities (such as a partnership or an S corporation) are considered in determining whether offsetting positions are held.
The loss deferral rule does not apply to positions in a regulated futures contract or other Section 1256 contract subject to the marked-to-market system explained later in this section.
The loss deferral rule also does not apply to businesses that must hedge in order to protect their supplies of inventory or financial capital. Hedging transactions are subject to ordinary income or loss treatment. Hedging transactions entered into by syndicates do not qualify for the exception and are subject to the loss deferral rule if more than 35% of losses for a taxable year are allocable to limited partners or entrepreneurs. Furthermore, hedging losses of limited partners or limited entrepreneurs are generally limited to their taxable income from the business to which the hedging transaction relates.
Conversion transactions.
On certain so-called “conversion transactions,” discussed at 30.10, gain realized on the disposition of certain positions is treated as ordinary income instead of capital gain.
Marked-to-market rules for gain or loss on regulated futures contracts and other Section 1256 contracts.
Gain or loss on regulated futures contracts is reported annually under the marked-to-market accounting system of regulated commodity exchanges. To settle margin requirements, regulated exchanges determine a party’s account for futures contracts on a daily basis. Each regulated futures contract is treated as if sold at fair market value on the last day of the taxable year. Any capital gain or loss is arbitrarily allocated: 40% is short term and 60% is long term. Use Form 6781 to figure gains and losses on Section 1256 contracts that are open at the end of the year or that were closed out during the year. These amounts are then transferred from Form 6781 to Schedule D.
Filing Instruction
Under the law, a regulated futures contract is considered a Section 1256 contract. Other Section 1256 contracts subject to the marked-to-market rules are foreign currency contracts, dealer equity options, and non-equity options.
The marked-to-market rules do not apply to true hedging transactions executed in the normal course of business to reduce risks and that result in ordinary income or loss. Syndicates may generally not take advantage of this hedging exception if more than 35% of their losses during a taxable year are allocable to limited partners or entrepreneurs. Further, the ability of entrepreneurs or limited partners to deduct losses from hedging transactions is generally limited to taxable income from the business to which the hedging transaction relates.
Mixed straddle contracts.
If you have a mixed straddle in which at least one but not all of the positions is a Section 1256 contract, the marked-to-market rules generally apply but you may elect to avoid this treatment and apply the regular straddle tax rules. The election, made on Form 6781, is irrevocable unless the IRS allows a revocation. Furthermore, the IRS allows an election to offset gains and losses from positions that are part of mixed straddles if you separately identify each mixed straddle or establish mixed straddle accounts for a class of activities for which gain and loss will be recognized and offset on a periodic basis.
Wash sales.
Rules similar to wash-sale rules apply to losses arising from sales of shares that make up a straddle if within a 30-day period you acquire substantially identical shares; see IRS Publication 550 for further details.
Contract cancellations.
Investors buying forward contracts for currency or securities may not realize ordinary loss by cancelling the unprofitable contract of the hedge transaction. Loss realized on a cancellation of the contract is treated as a capital loss.
Cash-and-carry transactions.
You may not deduct carrying costs for any period during which the commodity or stock or option is part of a balanced position. The costs must be capitalized and added to basis. The rule does not apply to hedging straddles. Capitalized items are reduced by dividends on stock included in a straddle, market discounts, and acquisition discounts. These reductions, however, are limited to so much of the dividends and discounts as is included in income.
Table 30-1 Key to Option Terms
| Item— | Explanation— |
| Call option | An option contract that gives the holder the right to buy a specified number of shares of the underlying stock at the given exercise price on or before the option expiration date. |
| Put option | An option contract that gives the holder the right to sell a specified number of shares of the underlying stock at the given exercise price on or before the option expiration date. |
| Strike price/exercise price | The stated price per share for which the underlying stock may be bought (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. |
| At-the-money | An option is at-the-money if the exercise price of the option is equal to the market price of the underlying security. |
| In-the-money | A call option is in-the-money if the exercise price is less than the market price of the underlying security. A put option is in-the-money if the exercise price is greater than the market price of the underlying security. |
| Out-of-the-money | A call option is out-of-the-money if the exercise price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security. |
| Premium | The price of the option contract determined in the competitive marketplace, which the buyer of the option pays to the option writer. |
| Intrinsic value | The amount by which the option is in-the-money. |
| Time value (premium-intrinsic value) | The portion of the premium that is attributable to the amount of time remaining until the option’s expiration date and to the fact that the underlying components that determine the value of the option may change during that time. |
| Secondary market | A market that provides for the purchase or sale of previously sold or bought options through closing transactions. |
| Expiration date | The expiration date is the last day on which an option may be exercised. |
| Writer | The seller of an option contract. |