For tax purposes, a straddle is a pair of transactions that is created by taking two offsetting positions. One of the two positions holds long risk and the other is short.
Note that this is a much broader definition than the options strategy known as a straddle. Nearly any trading strategy that involves a hedged position will trigger the straddle rules, as will any positions whose value vary inversely with each other. This includes being long and short the same stock, covered calls (but see qualified covered calls below), married puts, collars, iron condors, etc. Additionally, any positions marketed as offsetting positions will qualify, as will any position whose aggregate margin is lower than the sum of the margin requirements if held separately.
Generally speaking, there are two classes of straddles: basic and identified. These two classes differ in terms of how transactions become associated into the straddles.
An Identified straddle is created when the taxpayer flags two or more transactions to be grouped together as part of a straddle. A set of positions cannot be flagged as an identified straddle if it is part of a larger straddle.
A Basic straddle occurs when you have two or more positions that are offsetting, and none of these positions are in an identified straddle.
Additionally, a mixed straddle occurs if you have a straddle in which at least one position is subject to section 1256, and at least one position is not. Separate rules apply in that case, beyond the scope of this page.
For an identified straddle, any loss is disallowed if there are offsetting positions still open. The basis of the offsetting positions is adjusted by the amount of the disallowed loss. The loss is then recognized when that position is disposed of (subject to potential further disallowal due to straddle and wash sale rules, of course)
For a basic straddle, the comparison is made at the end of the year. The amount of the loss is compared to the amount of the unrecognized gain on offsetting positions as of the end of year. The amount of the loss in excess of the unrecognized gain (if any) can be recognized, the loss up to this amount is deferred until the following year. At the end of the following year, the loss is then compared to the unrecognized gain as of the end of that year, following the same rule. Of course, if all of the positions of the straddle are closed out during a year, then there will be no unrecognized gain at the end of the year, and all the loss will be allowed.
For computing the unrecognized gain, positions which have an unrecognized loss are ignored. Only the positions which have an unrecognized gain are summed.
Additionally, certain transactions can also be delineated as Qualified Covered Calls (QCC). This has the effect of excluding any straddle from a Qualified Covered Call and the underlying stock. However, the QCC or the underlying stock can be included as elements of other straddles — in which case the standard straddle rules apply.
A covered call is comprised of a long equity position and a short (‘written’) call option. In order for it to be qualified, the principle rules are (a) the straddle consisting of the option and the equity is not part of a larger straddle, (b) the option is granted more than 30 days before it expires, and (c) the option is not deep-in-the-money, as defined by § 1092(c)(4)(C).
Example — Basic Straddle
- 01/05/2011 Buy a call option on 100 shares of ABC for $100.
- 01/06/2011 Buy put option on 100 shares of ABC for $200.
- 12/01/2011 Sell a call option for a loss of $11.
- 12/31/2011 The put option is worth $205, for an unrealized gain of $5.
|Basic Tax Straddle
||Call Option for ABC
||Put Option for ABC
||Call Option for ABC
Example 2 — Identified Straddle
- $5 of the $11 loss is disallowed. The $6 loss is allowed as Short-term loss for the tax year of 2011, and the $5 short-term loss is carried over until 2012, subject to another application of the straddle rules.
- The holding period of the put option begins on 12/01/2011, the date on which it was no longer in a straddle.
Activity: Same as example 1, but the fund ‘identifies’ the two transactions as belonging to a single straddle.
The entire $11.00 is disallowed in the tax year of 2011; the cost basis of the put option is adjusted upward by $11, to $211.
The holding period of the put option begins on 12/01/2011, the date on which it was no longer in a straddle.
Example 3 — Qualified Covered Call
- The fund buys 100 shares of ABC stock on January 5th, 2011 for $1000.
- On October 30th of 2011, the fund sells short (‘writes’) an out-of-the-money call option with an expiration date of June 30th, 2012, for $200.
- On October 31st, the fund sells the ABC shares for a $990, a $10 realized loss.
- The short call option shows an unrealized gain of $5.00 at close of business, December 31st, 2011.
- The written call option meets the requirements of being a qualified covered call.
||Call Option for ABC
Result: Although the two transactions would normally be tagged as a basic straddle, since they were exempted by being a QCC and it’s underlying stock, the $10 loss is allowed in the tax year of 2011.
For a more in-depth discussion on both cost basis and holding period adjustments and calculating disallowed losses as related to straddles, please read our white paper, Tax Implications of Straddles, in our White Papers Section.
IRC 1092(a)(1)(A) provides that “Any loss with respect to 1 or more positions shall be taken into account for any taxable year only to the extent that the amount of such loss exceeds the unrecognized gain (if any) with respect to 1 or more positions which were offsetting positions with respect to 1 or more positions from which the loss arose.”
IRC 1092(a)(2)(A)(ii) provides that “if there is any loss with respect to any position of the identified straddle, the basis of each of the offsetting positions in the identified straddle shall be increased by an amount which bears the same ratio to the loss as the unrecognized gain with respect to such offsetting position bears to the aggregate unrecognized gain with respect to all such offsetting positions.”
Throughout the 1960s and 1970s, commodity straddles and other transactions, such as “T-Bill Straddles” and “Cash and Carry Trades” were aggressively marketed by brokers to non-professional investors as tax shelters. The most well-known example of straddle abuse is the now infamous “Silver Butterfly Case.” The case was based on the actions of two investors, who, in 1973 executed 84 long futures transactions and 84 short futures transactions on silver. By the end of the calendar year, they had both significant unrealized losses and gains on the individual positions with a net profit of close to zero. They then closed out some of the losing positions before year end to offset some short term real-estate gains they had made earlier in 1973. The IRS decided to audit and disallowed the losses. In 1977, the IRS published a ruling (77-185) to support its decision. Unfortunately, there was no support in the tax code for this ruling, so the issue had to go to Washington for resolution.
When this issue came to the attention of Congress, it sparked an epic battle between Dan Rostenkowski (Democratic Representative from Illinois) and Patrick Moynihan (Democratic Senator from New York). Moynihan and others fought to close this loophole. At the climax of the struggle, when the issue came to a vote, Moynihan exclaimed that before learning about straddles, in particular butterfly straddles, he had assumed “a butterfly straddle must refer to a highly pleasurable erotic activity popular during the Ming
Dynasty.” (Schwartz, 1999*)
In the end, Moynihan won the fight and Congress added section 1092 to the tax code via Title V of the Economic Recovery Tax Act of 1981 (ERTA). Simply put, section 1092 disallows losses on the retired leg(s) of a straddle to the extent of the unrealized gain on the non-retired leg(s) at the end of the tax year.
The next year, on March 5, 1982, the Tax Court decided that the “Silver Butterfly” employed in 1973 as a tax shelter was within the law. Since the code was changed in 1981 (via ERTA), all tax straddles executed prior to ERTA ultimately were considered legitimate.
- Tax Implications of Straddles This webinar provides an introduction to Straddles, section 1092 of the IRC. It covers basic, mixed & identified straddles as well as qualified covered calls as related to calculating realized gains & losses on investment portfolios.
- Wash Sales, Constructive Sales & Straddles: A Primer This webinar provides an overview of the aforementioned taxable events (Sections 1091, 1259 and 1092 of the IRC) and how they affect realized gains & losses.
- Tax Implications of Straddles This paper discusses two issues integral to cost basis calculations: (1) how to calculate taxable gains and losses for straddles transactions, per Section 1092 of the tax code, and (2) how to account for the effects of other taxable events, such as wash sales, on straddles and vice versa. Examples are included.
Click here to read about straddles in Pub 550, the IRS publication that provides information and guidance on complying with sections of the Internal Revenue Code (IRC) that pertain to investment income and expenses.
Click here to read specifically about straddles, as described in Pub 550.
Another useful on-line resource to research different sections of the IRC is the Legal Information Institute (LII) site, which is published by Cornell University Law School.
*Schwartz, M. F. (1999). Pit Bull: Lessons from Wall Street's Champion Day Trader. New
York: Harper Collins.