BillBischoff

The current federal income tax rates on long-term capital gains are super low, ranging from 0% to 15% depending on your tax bracket. But the rates on short-term gains are not so low. They range from 15% to 35% for most investors. That’s why, as a general rule, you should try 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 Internal Revenue Service won’t be able to take more than 15% of your profits.

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Unfortunately, today’s investment climate is not necessarily conducive to making such long-term commitments. Instead of following the conventional buy-and-hold strategy, buy-and-hope might seem more appropriate right now. But that can result in short-term gains that get heavily taxed.

The good news: There are some strategies you can use to rake in short-term gains without getting hosed with higher taxes. Here goes.

Sell Unlovable Losers to Create Capital Losses

Stocks Resources

Usually I talk about harvesting capital losses, by selling loser stocks (worth less than you paid for them), in the context of yearend planning. But it works earlier in the year, too. 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 yearend, you can carry them forward to 2012 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 shares for at least a year and a day in order to pay a lower tax rate. You have greater flexibility without paying a tax price.

Consider Trading in Broad-Based Equity Index Options

One popular way to place short-term bets on broad stock market movements is by trading in exchange-traded funds like QQQ, -0.43% (which tracks the NASDAQ 100 index) and SPY, -0.61% (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 35%. Ditto for short-term gains from precious metal ETFs like GLD, +0.14% or SLV, -0.13% (under a special unfavorable rule, even long-term gains from precious metal ETFs can be taxed at up to 28%).

Thankfully, there’s a way to play the market in a similar short-term fashion while paying a lower tax rate on our gains. Consider trading in broad-based equity index options.

Favorable Tax Rates for Short-Term Gains

The tax law treats these options, which look and feel a lot like options to buy and sell comparable ETFs, as Section 1256 contracts. That’s a good deal because gains and losses from trading in Section 1256 contracts are automatically considered 60% long-term and 40% short-term. In other words, your actual holding period for a broad-based equity index option doesn’t matter. The tax-saving result is that short-term profits from trading in broad-based equity index options are taxed at a maximum effective federal rate of only 23%. If you’re in the top 35% bracket, that’s a whopping 34% reduction in your tax bill. The effective rate is lower if you’re not in the top bracket. For example, if you’re in the 25% bracket, the effective rate on short-term gains from trading in broad-based equity index options is only 19%. That’s a 24% reduction in your tax bill.

Bottom Line: With broad-based equity options, you pay a significantly lower tax rate on gains without having to make any long-term commitment. In today’s turbulent investing environment, that’s a nice advantage.

Yearend Mark-to-Market Rule

As the price to be paid for the favorable 60/40 rule, you must follow a special mark-to-market rule at yearend for any open positions in broad-based equity index options. That means you pretend to sell your positions at their yearend market prices and include the resulting gains and losses on your tax return for that year. (If you don’t have any open positions at yearend, this rule won’t affect you.)

Finding Broad-Based Equity Index Options

A fair number of options meet the tax-law definition of broad-based equity 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 major industry and commodity sectors like utilities, tech, oil and gold. One place to find options that qualify as broad-based equity index options is here. While trading in these options is not for the fainthearted, it’s something to think about if you consider market volatility your friend.

Note: To understand the general tax rules that apply to profits and losses from trading in stock options, see here. The tax treatment of profits and losses from trading in broad-based equity index options is the same — except for the special 60/40 and the mark-to-market rules.