In some cases, you can hold a stock for less than a year and avoid short-term capital-gains rates
The current federal income-tax rates on long-term capital gains recognized by individual taxpayers are still low by historical standards. The rates range from a minimum of 0% to a maximum of 20% depending on your tax bracket. But the rates on short-term gains aren’t so low. They currently range from 15% to 39.6% for most investors. That’s why, as a general rule, you should try hard to satisfy the more-than-one-year holding period requirement for long-term gain treatment before selling winner shares (worth more than you paid for them) held in taxable brokerage firm accounts. That way, the IRS won’t be able to take more than 20% of your profits (or 23.8% if the dreaded 3.8% net investment income tax applies).
However, you may think that today’s somewhat frothy stock market valuations aren’t conducive to making such long-term commitments, even though short-term gains are heavily taxed. What to do? Here are some thoughts on how to rake in short-term gains without getting hosed with much higher taxes.
Sell unlovable losers to create capital losses
Usually I talk about “harvesting” capital losses, by selling loser stocks (worth less than you paid for them), in the context of year-end tax planning. But it works earlier in the year too, like now. Capital losses from selling unlovable losers can be used to shelter short-term gains collected anytime this year. If you have any leftover capital losses at year-end, you can carry them forward to 2018 and use them to shelter short-term gains collected next year and beyond. In other words, to the extent you have capital losses, there’s no need to hang onto winner shares for at least a year and a day in order to pay a lower tax rate.
Consider trading in broad-based stock index options
One popular way to place short-term bets on broad stock market movements is by trading in ETFs like QQQ (which tracks the NASDAQ-100 index) and SPY (which tracks the S&P 500 index). Unfortunately when you sell ETFs for short-term gains, you must pay your regular federal tax rate, which can be as high as 39.6% (or 43.4% if the 3.8% net investment income tax applies). Ditto for short-term gains from precious metal ETFs like GLD or SLV. Under a special unfavorable rule, even long-term gains from precious metal ETFs can be taxed at up to 28% (plus another 3.8% if the net investment income tax applies), because the gains are considered collectibles gains. Rats!
Thankfully, there is a way to play the market in a short-term fashion while paying a lower tax rate on your gains: consider trading in broad-based stock index options.
Favorable tax rates on short-term gains from broad-based index options
Our beloved Internal Revenue Code treats broad-based stock index options, which look and feel a lot like options to buy and sell comparable ETFs, as Section 1256 contracts.
Section 1256 contract treatment is a good deal for investors because gains and losses from trading in Section 1256 contracts are automatically considered to be 60% long-term and 40% short-term. So your actual holding period for a broad-based stock index option doesn’t matter. The tax-saving result is that short-term profits from trading in broad-based stock index options are taxed at a maximum effective federal rate of only 27.84% [(60% × 20%) + (40% × 39.6%) = 27.84%], or 31.64% if the 3.8% net investment income tax applies. If you’re in the top 39.6% bracket, that’s a 29.7% reduction in your tax bill (ignoring the possible impact of the net investment income tax).
The effective rate is lower if you’re not in the top bracket. For example, say you’re in the 25% bracket. The effective rate on short-term gains from trading in broad-based stock index options is only 19% [(60% × 15%) + (40% × 25%) = 19%]. That’s a 24% reduction in your tax bill.
Bottom line: With broad-based stock index options, you pay a significantly lower tax rate on gains without having to make a long-term commitment. That’s a nice advantage.
Favorable treatment for losses too
If you suffer a net loss from trading in Section 1256 contracts, including losses from broad-based stock index options, you can choose to carry back the net loss for three years to offset net gains from Section 1256 contracts recognized in those earlier years, including gains from broad-based stock index options. In contrast, garden-variety net capital losses can only be carried forward.
Year-end mark-to-market rule
As the price to be paid for the aforementioned favorable tax treatment, you must follow a special mark-to-market rule at year-end for any open positions in broad-based stock index options. That means you must pretend to sell your positions at their year-end market prices and include the resulting gains and losses on your tax return for that year. Of course if you don’t have any open positions at year-end, this rule won’t affect you.
Finding broad-based stock index options
A fair number of options meet the tax-law definition of broad-based stock index options, which means they qualify for the favorable 60/40 tax treatment. You can find options that track major stock indexes (like the S&P 500 and the Russell 1000) and some major industry and commodity sectors like biotech, oil, and gold. One place to find options that qualify as broad-based stock index options is tradelog. While trading in these options isn’t for the fainthearted, it’s something to consider if you want better tax results for your profitable short-term stock market bets.
Bill Bischoff
