How do you handle taxes on covered calls?

-- Ron Louis

Ron,

Although we've addressed this before, the tax implications of option trades are complicated enough to bear repeating.

Calls are a type of option that give the purchaser the right -- but not the obligation -- to buy a security at a specified price at a certain time. They're basically a bet that the stock will go up. An investor buys calls when he sees upside potential in a stock but doesn't have either the cash or the guts to make a full-scale equity commitment. (For more on calls and options investing in general, see Mirror Mirror on the Wall, Explain for Me a Put and Call.)

Investors can also take the other side of the transaction by selling (or in market parlance, "writing") calls. The writer of a call is obligated to deliver stock if the buyer exercises his option. The writer gets a fee, called a premium, for taking on this obligation. If all goes well for the writer, the option will expire worthless and the writer walks away with the premium.

An option is considered "covered" when the person writing the calls already owns the underlying stock, for example, writing calls on shares of Cisco (CSCO:Nasdaq - news) you hold in your portfolio. If you don't own the underlying stock, you have written a "naked" call, a riskier move.

As the writer of a covered call, the following things can happen, tax-wise:

• The call expires worthless. The premium you received is reported as a short-term capital gain.

• You buy back the call. The difference between the amount you paid to buy back the call and the premium you received is reported as a short-term capital gain or loss.

• The underlying stock is called away (the buyer of the call exercised his right to take delivery of the shares). Your profit or loss on the sale of the stock is added to the premium you received for writing the call. You pay capital gains tax on the total. Whether the gain is short-term or long-term depends on how long you held the stock -- not the option.

Check the Internal Revenue Service's Publication 550 -- Investment Income and Expenses for more details. There's a great chart on page 54 that walks you through the tax implications of calls and puts.

Child-Care Credit Limits

Is there an income phase-out for the child-care credit if one meets the test? (We're a high-income family.)

-- Norman Yap

Norman,

You should know by now that all good things have income limitations in the tax world.

First, there are two credits that concern your kids, both of which run up against income limitations.

One is the child tax credit, which allows you a flat $500 for each dependent child under age 17. The child tax credit phases out if your adjusted gross income is above $110,000 for joint filers, $75,000 for unmarried individuals and $55,000 for those who are married and filing separately.

The credit you're asking about is the child and dependent care credit, which you can take to offset qualifying child-care expenses.

If you paid someone to take care of your child so you can work, that cost may qualify as a child-care expense. To be eligible, your children must be under 13 and live with you. You are not eligible if you are married and filing separately. For more details on the requirements for qualifying for the credit, check out this previous Tax Forum.

The maximum annual credit is $2,400 for one child or $4,800 for two or more. The actual amount of child-care expenses that qualify for the credit are limited by a percentage of your adjusted gross income. If your adjusted gross income is over $28,000, you must multiply your qualified child-care expenses by 20% to determine your tax credit. So if your qualified expenses total, say, $15,000, only $3,000 (15,000 x 20%) will be allowed as your child-care credit (if you have two or more kids).

The percentages increase for incomes under $28,000 and max out at 30% for families with adjusted gross incomes under $10,000. See Form 2441 -- Child and Dependent Care Expenses for more details on these percentages.

File Your Taxes Already!

Here's your last warning. If you put your 1999 Form 1040 -- U.S. Individual Tax Return on extension back in April, it's due at midnight tonight. So shake a leg.

If you're not prepared to file by midnight, fill out Form 2688 -- Application for Additional Extension of Time to File U.S. Individual Income Tax Return. But a second extension request requires an explanation, and the IRS must approve it. "The summer's been so busy" won't cut it. If you are still waiting for tax information from partnership interests or overseas investments, that would work.

If you started to prepare your tax return back in April using a tax software program, that program should have the extension form. If not, just print it off the IRS Web site and mail it in. It must be postmarked today.

If the IRS approves your request, you'll have until Oct. 15 to finish up your 1999 tax return. If your request is denied, you have 10 days from the date you get the bad news to mail in your return.

If you owed taxes, your bill was due with your original extension back in April. If for some reason, you miscalculated and you owe more, you'll owe late filing fees and interest on that extra amount.

If you don't have enough cash available, call 888-2PAY-TAX and charge your taxes to your American Express, Discover or MasterCard. Check out this previous Tax Forum for more details.