A Smart Tax Move for Short-Term Investors

Federal income tax rates on long-term capital gains are historically low right now, ranging from a minimum of 0% to a maximum of 15%. In stark contrast, federal tax rates on ordinary income, including short-term capital gains, range from 15% to a hefty 35% for most investors. That’s why many investors try to satisfy the more-than-one-year holding period requirement before selling the equity instruments held in their taxable investment accounts. That way, the IRS won’t be able to lay claim to more than 15% of their profits.

However, you've probably noticed that the investment climate is just a wee bit unsettled right now. While you might be interested in making some equity plays, you might not want to make any long-term commitments. Who can blame you?

One common way to place short-term bets on broad movements in the stock market is by trading in ETFs (exchange traded funds) like the PowerShares QQQ Trust (QQQQ) (which tracks the 100 largest non-financial companies listed on the NASDAQ) and the SPDR Trust (SPY) (which tracks the S&P 500 index). ETFs can be bought and sold during the trading day just like stocks. Unfortunately, if you sell ETFs for short-term profits, you’ll have to pay your ordinary income tax rate--which can be as high as 35%. Ouch! But don’t give up hope. There is a way to invest short-term and pay a lower tax rate on your gains without having to meet the burdensome more-than-one-year holding period requirement. Here’s how:

Special Tax Rules Apply to Broad-Based Equity Options

To reduce the tax hit on short-swing stock market gains, consider trading in broad-based equity index options. These options allow investors to bet on the moves of a broad-based stock index. For example, SPX options track the S&P 500. So broad-based equity index options basically look and feel a lot like options to buy and sell ETFs. Here's the good part: Tax law treats broad-based equity options as Section 1256 contracts. This is beneficial to you because gains and losses that are realized from trading in Section 1256 contracts are automatically considered to be 60% long-term and 40% short-term. In other words, your actual holding period for a broad-based index option doesn’t matter.

The tax-saving result is that short-term profits from broad-based equity index options are taxed at a maximum effective federal income tax rate of only 23% [(60% x 15%) + (40% x 35%) = 23%]. That’s a whopping 34% reduction in your tax bill. The effective rate is even lower if you’re not in the top 35% bracket. For example, if you’re in the 25% bracket, the effective rate on short-term gains from trading in these options is only 19% [(60% x 15%) + (40% x 25%) = 19%]. That’s a 24% reduction in your tax bill.

Just Be Aware of Year End Mark-to Market Rule

Of course, there's a price to be paid for the favorable 60/40 tax rule. Investors must adhere to a mark-to-market tax rule at the end of the year for any open broad-based equity index option positions. This means you pretend to sell your options at their year end market prices and report whatever the resulting gains and losses are on your Schedule D for that year. However, keep in mind that the mark-to-market rule only comes into play for those with open positions at year end. Otherwise, it doesn't apply.

Make Sure to Find Options That Qualify as Broad-Based

A fair number of options meet the tax-law definition of broad-based equity index options, which means they qualify for favorable 60/40 tax treatment. You can find options that track major stock indexes and major industry sectors like oil, pharmaceuticals, defense, biotech, and so on. One place to learn which options qualify as broad-based equity index options is the web site for Twenty-First Securities, an outfit that specializes in hedging and arbitrage strategies. While trading in these options is not for the faint of heart, it’s something to think about for those who consider stock market volatility to be their friend. If you're one of those folks, I expect we will see enough volatility to keep you satisfied.

Note: To understand the general tax rules that apply to profits and losses from trading in stock options, read our story "Taxes on Options -- Puts and Calls". The tax treatment of profits and losses from trading in broad-based equity index options is the same--except for the 60/40 rule and the mark-to-market rule.