Wash Sale Rule for Options?

I'm not trading for a living but do trade quite a bit. Recently have been trading QQQ options.

I need to know what the rules are for wash sales regarding options. I had some losses in Dec QQQ options which were closed out in the beginning of December. Have since traded Jan QQQ options profitably since then and closed those out also.

If I buy new QQQ options today (Dec. 31) and hold them into next year, or if I buy some QQQ options in the first part of January, will it trigger a wash sale because I traded some QQQ options for a loss in early December?

In other words, is it a wash sale if I am using different months and strike prices from the options which I traded for a loss, or is it applied only to the same option security? What about if I traded puts for a loss before and am now trading calls or vice versa?

How long do I need to wait since the last loss to avoid a wash sale?

Thanks for any info,
Mike

 

Hi Mike:

We are confronted here with a situation in which there is an appalling lack of guidance from Congress or the IRS on this issue. As a result, I can tell you what the cutting edge view is, but there is no precedent upon which taxpayers can rely.

Bear with me as I lay out the parameters. The critical language in Code section 1091 is “substantially identical stock or securities.” Thus the issue is whether options traded for a loss constitute “substantially identical stock or securities” if those options involve different expiration dates and strike prices.

The code and regulations offer no help. They do not address whether differences in dates or strike prices are sufficient to take the option out of the wash sale rule. Congress has provided us no guidance for the determination of whether an option or contract is substantially identical to another.

The leading case mentioned in the commentaries is Hanlin v. Commissioner, an old case decided by the 3d Circuit in 1939, which decided whether certain bonds were substantially identical to one another. The test adopted by the Hanlin court for analysis of the wash sale rule for bonds is whether the taxpayer’s “economic position” has been changed. Over the years a substantial body of authority has developed for bonds, so one can say with reasonable certainty that the test for bonds is that bonds are not “substantially identical” for wash sale purposes if they differ in any material feature, such as interest rate, interest payment dates, redemption provisions, or maturity date.

So how do you apply this analysis to options? The best guidance we have from the IRS is General Counsel Memorandum 38285 (1980). In that GCM, the IRS analyzed whether exchange traded call options for the same underlying stock, with the same expiration date, BUT with a different strike price, were “substantially identical” for wash sale purposes. Specifically, the facts involved options that were identical in all respects except the calls that had been sold at a loss had a strike price of $40. The replacement options had a strike price of $45.

The GCM analysis is that two options that are identical in every respect except the strike prices are substantially identical for purposes of the wash sale rule. However, the GCM hedges its bet (no pun intended) by noting that two call options might be materially different—and hence outside the wash sale rule—if the exercise price of one of the options is significantly higher than the current price of the underlying stock. The GCM gives no guidance as to what would constitute a “significantly higher” strike price.

We have no tax cases after 1989, the date when Congress changed the wash sale statute to explicitly include options within the scope of the wash sale rule. Nor do we have any more recent Revenue Rulings or GCM guidance.

My research turned up a well-written article in a 1989 issue of Tax Lawyer, written in response to the 1989 revision of the wash sale statute. In that article, the author analyzes this whole mess in great depth and detail, and proposes the following rules:

Options which are similar in all respects other than strike price are “substantially identical” unless one of them is significantly in-the-money and the other is significantly out-of-the-money. As to expiration dates, the wash sale rule should not apply to options which are identical in all respects other than time to maturity.

I need to caution you that the rules quoted above are simply the opinions of the author who wrote the article. It is a well-reasoned and persuasive article, but the IRS has not adopted these rules—except with respect to the GCM dealing with calls identical in all respects except the strike price. Even then, the GCM states that taxpayers are not entitled to rely on it or cite it as precedent.

Some day we’ll have better guidance on the application of the wash sale rule to options. The IRS could, and should, clarify this area. But until they do, the analysis set forth above is the best and most current available.