Unrealized Capital Gains And The Stars and Stripes Top Hat

Unrealized Capital Gains

Lets face it, most of us; save for the bearded gentleman with the tall patriotic top hat, loathe the sight of April 15 on the calendar.  For some of us, it’s the day where the spotlight shines to remind us of the real value our tax dollars are providing to society’s greater good.  

For the balance of us though, its the verification of just how much our tax dollars go to fund the bloated, ever-growing, unaccountable leviathan, we call government.. 

Whatever your political persuasion is, it really doesn’t matter, both sides are to blame.  For us; ‘cogs in the wheel’ we’re perpetually subjected to taxes going up, while our representation goes down, and our voices shrink with every passing election.

While this post is not about ‘calling out’ our leaders due to their lack of fiduciary responsibility with regard to our hard-earned money, their complicity is certainly recognized.  

Instead, in an effort to maintain positivity, we will focus on what we can do to minimize the ‘hit’ we take on taxes when it comes to unrealized capital gains with option trading

What are Unrealized Capital Gains

Unrealized Capital Gains are when an asset increases in value, but the increase is never exercised because the asset owner does not sell it to the market.  It’s the proverbial ‘paper increase’ in value.  Truth be told, it’s imaginary money.  

If I have a house, like this one, that I bought for $100,000 5 years ago, that now has a perceived market value of $125,000, well the $25,000 is considered an unrealized capital gain.  It’s considered unrealized, because the sale is not executed to confirm the true market value.     

Where do Unrealized Capital Gains and Options intersect? 

Let’s say you bought Tesla stock back in 2020 when it was selling for the low low price of $44.  Now, I say this a bit ‘tongue and cheek’, because it’s hard to imagine Tesla trading that low when it’s shares recently reached a ‘split adjusted’ price of $407 back in 2021.

But let’s imagine; for illustrative purposes, you had the incredible foresight to buy a couple hundred shares of Tesla for $44 and never sold.  And, now you want to write Covered Calls against those shares.

Whoa wait, what are covered calls.

Covered Calls are a contract between a buyer and a seller, where the buyer has the right to buy shares of a stock at a certain strike price on a certain date, and the seller has the obligation to sell those shares of stock at the same strike price on the same date.

If you want to read more about building a consistent income stream using options, check this post out.

For this right, the buyer pays the seller a premium, which is available to the seller immediately.

The Option Buyer generally has a bullish sentiment about the stock, while the Option Seller has a bearish sentiment.

When the premium you get paid is not worth collecting.

If you rode the stock price up from $44 to it’s current price of $180 and hadn’t sold any shares along the way, you’d have no tax liability, only an unrealized capital gain..  

But, if you write covered calls against those Tesla Shares and your chosen strike price is reached, your shares get ‘called away’.  And in the eyes of the bearded guy with the patriotic top hat, you’ve now sold your shares. 

And because you sold your shares…..

All the gain from the rise in price from $44 to $180 is taxed, all at once.  And the premium you collected (because you were the seller of the option) well that becomes taxable as well.   And, to make matters worse, it’s taxed as ‘Ordinary Income’ which generally means you pay a higher tax rate than say Short or Long-Term Capital Gains. 

So, it’s important to consider whether the premium you collected when you initiated the covered call trade is worth the potential ‘sales risk’.  If you’ve owned the shares of the underlying asset you’re writing covered calls against for a long time, you may want to step back and say, how will this impact my taxes.

It’s one thing to pay taxes on a few hundred dollars of premium you collected, it’s a whole nother thing to pay taxes on the sale of a high alpha asset, when you weren’t really intending to sell it. 

The moral of the story is, it’s always prudent to consider the tax implications on the sale of any asset.  However, with Option Trading, you have another variable to consider- Could the sale of this asset create a tax burden which would negate any amount of premium I would collect?

If the answer to this question is ‘yes’, you may want to consider using a different underlying asset, one with a lot less alpha, to write your covered call with.  Doing so, may show that gravelly top-hat wearing patriotic man who the real genius is here!

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