Hedging: Tax Traps for the Unwary

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Hedging: Tax Traps for the Unwary
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
August 1, 2007

In Hedging Your Investments, we talked about using a hedge as a way to help defend against financial loss, particularly if you're overly concentrated in a single stock. Investment hedges can also be used to help offset potential losses in a portion of your diversified portfolio—or your entire portfolio—when you're temporarily unwilling or unable to enter into an outright sale.

Before you consider a hedge, you need to be aware of the important tax rules that come into play whenever you enter into an offsetting position. Running afoul of these rules could severely limit the effectiveness of your hedging strategy. Talk to your CPA or other tax professional to see how the following rules (and related IRS and state tax rules) might apply to your particular situation.

Straddle rules
According to the IRS, a straddle is an "offsetting position with respect to personal property." When you enter into an offsetting position to limit the risk on another position—as you do with a hedge—the straddle rules usually come into play. Straddle rules are complex, but here are some key points to keep in mind:

You may have to wait to deduct any losses. If you have a capital gain in one position of a straddle and a capital loss in the other, you can't recognize the loss for income tax purposes until you dispose of both positions. For example, let's say you had a highly appreciated stock position and you purchased protective put options (which give you the right to sell the stock to someone else for a period of time at a predetermined price) to offset the risk. However, the stock continued to rise and your put options expired worthless. You must defer recognition of the loss on your put options until you sell and recognize the gain on the original, appreciated position.
Your capital gain holding period may get clipped. The moment you enter into a typical straddle, the capital gains holding period on your offsetting positions is frozen. This isn't such a big deal if you've already held the original, appreciated position for more than one year (qualifying for the long-term capital gains rate). But if you've held the original position one year or less, not only is the holding period frozen, it starts all over again when you dispose of the offsetting position.

In most cases, a hedge will be ineffectual if your goal is to protect your short-term position while you wait for long-term treatment.
You may not be able to deduct any interest expenses or carrying charges. During the offsetting period, any interest or carrying charges associated with the straddle are not currently tax deductible, but must be capitalized (added to cost basis).

Constructive sale rules
The constructive sale rules arrived as part of the Taxpayer Relief Act of 1997. In a nutshell, certain offsetting transactions can require you to recognize the capital gain on your original position even though you haven't actually sold it. These rules severely limit the usefulness of an old standby, the "short-against-the-box" strategy.

Importantly, a put option used by itself to hedge the risk on an existing position should not trigger a constructive sale as long as the exercise price is at or below the price of the existing position. And there are a number of other viable hedging and diversification strategies which, when properly structured, can help avoid constructive sale treatment.

Qualified dividends
Under the Tax Relief Act of 2003, qualified stock dividends are taxed at the long-term capital gains rate of 15% through December 31, 2010.* However, in order to receive qualified dividend treatment, the stock must remain unhedged during the required holding period (more than 60 days during the 121-day period surrounding the ex-dividend date).

Sunset on the long-term capital gains rate
Hedging transactions typically involve multi-year planning for taxes and other cash flows. For example, you may enter into a hedging contract that defers your capital gains for one, two or three years. Keep in mind the long-term capital gains rate of 15% will jump up to 20% for sales after Dec. 31, 2010, unless Congress acts before then to extend the lower rate or make it permanent. As the sunset date approaches, deferring gains might not be your best decision, all else being equal.

Get expert help
For more information on straddles, constructive sales and related tax rules (including information on the tax treatment of options), see IRS Publication 550: Investment Income and Expenses. We strongly recommend getting expert help, preferably from both your trusted investment advisor and tax professional working together.

Also, beware of tax strategies that sound too good to be true, such as tax elimination schemes (as opposed to tax deferral), offshore deals and the like.

A final point to keep in mind: Just because hedging is a sophisticated solution doesn't mean it's the best solution for your situation. Sometimes it makes more sense to take your gain, pay your taxes and move on. Likewise, gifting appreciated long-term positions to family members or qualified charities can be a tax-effective way to diversify out of a concentrated position.

We'll look at some common hedging techniques next, in "Strategies for Hedging and Diversification."

Important Disclosures

*For people in or below the 15% ordinary income tax bracket, the long-term capital gains rate is 5% through 2007, and goes to zero in 2008.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Call your local Schwab office or write Charles Schwab & Co., Inc. 101 Montgomery Street, San Francisco, CA 94104 for a current copy.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies may not be suitable for you. We believe the tax information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

Charles Schwab & Co., Inc., Member SIPC.

(0807-6388)

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