The covered call options strategy is a great way to create reliable income from your stock positions while reducing risk.

In addition to generating solid returns, covered call traders can receive some very attractive tax advantages.

But many investors “forget” about this strategy.

What are covered calls, and how can you use them in your portfolio? We’ll cover all the bases in this article.

What Are Covered Calls?

A covered call is a trade in which you own the equivalent amount of an underlying security to the call options you sell.

Ideally, for this strategy, you want to buy (or already own) a quality stock with strong fundamentals.

It doesn’t matter if the stock is treading water or showing positive price action — the strategy won’t work with stocks that are about to take a nosedive.

A call option gives the owner the right but not the obligation to buy 100 shares at a specific price within a defined period.

By selling these call contracts, you give someone else the right to buy 100 shares from you at a specific price. You get paid to sell this right, which is how you generate income in the form of a premium.

On the expiration date, if your stock trades above the designated price (called the “strike price”), you must fulfill the obligation and sell your stock. But if the stock trades below the strike price, you get to keep your stock. You also get to keep the payment you received for selling the option contract.

Tax Treatment of Covered Call Options

As a general rule, the payment you receive from the option contract can be classified as a reduction in the cost basis of the stock. This is important — especially when it comes to taxes.

For instance, say you bought a stock at $50 and sold March $55 calls against the position for $3 per share. Your net cost for the position is $47. If the stock remains below $55 and the calls expire, you should not have to pay taxes on the $300 income ($3 per share x 100 shares) you received by selling the call contracts.

Instead, you now own shares of the stock with a lower cost basis.

Some traders continue to sell calls against their stock positions. This continually creates income in their portfolio while slowly reducing the cost basis for their stock.

The total gains are reported as taxable gains when the stock is eventually sold.

But there is a definite advantage in deferring the tax liability until the position reaches “long-term gain” status or simply into the next tax reporting period.

The best tax advantage for covered call trades is when you can hold the original stock position for a full year. This allows you to sell four, five, or even six different contracts against your position.

If you sell calls with a high-enough strike price so that you are not obligated to sell shares, things get interesting. You can continue to generate income all year long and have this income taxed at the long-term rate.

Remember, short-term capital gains are taxed as ordinary income according to federal income tax brackets.

For many, this can represent significant savings, depending on your tax bracket. This also makes a considerable difference when you look at the long-term return rate of your taxable investment account.

The key is to hold the underlying stock through an entire 12-month period rather than selling.

There are also instances in which it makes sense to use covered calls to defer a tax liability. Even if the trade is ultimately recorded as a short-term gain, deferring the trade into the next tax year can give you the use of all your capital for an additional 12 months.

This is in contrast to paying the short-term tax gain in the current year. In that case, you would have a smaller capital base for generating income in the following year.

A Creative Approach

Remember, it never makes sense to stick with a poor trade simply for tax reasons. Also, remember we are not tax professionals and rules sometimes change. So it’s best to consult with a professional if you are unsure.

That said, there are some tricks you can use with strong covered call options trades to extend the life of the position and potentially hold for long-term gains.

There are times when a covered call position trades higher than the strike price. That means you will be obligated to sell your stock when the call contract expires.

But let’s say the stock is still trading in a healthy pattern. And you find call attractively priced contracts expiring further down the road… You could elect to buy more stock at the higher price and then sell additional calls against the new stock.

Technically speaking, you’re simply setting up a new covered call position with the same stock. But when the original calls expire, you can choose which block of stock to exercise them against.

In this case, you could sell the second lot of stock purchased at a higher price. In all likelihood, you will recognize an accounting loss on this second block (which is good for tax purposes). But you’re still holding your original position with a much lower cost basis.

Using this strategy allows you to keep your block of stock at the lowest cost. It also defers your tax liability until you have held it long enough to qualify for long-term gains. Or it can serve to defer liability into the next calendar year.

The Bottom Line

Of course, you should speak with your accountant about your individual situation before implementing these tax-deferral strategies in your account. There may be extenuating circumstances that would be important to know before using this options strategy for tax purposes.

That said, covered call options can generate tremendous returns. And they are potentially much more tax-friendly than most other trading strategies.

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