Do Covered Calls Affect Your Long-Term Capital Gains Tax Treatment on Shares You've Held Over a Year?

The Short Answer: Yes, Covered Calls Can Affect Your Long-Term Status

Yes, selling a covered call can disrupt the long-term capital gains tax treatment on shares you have held for more than a year — but only under specific conditions. If the call you sell is classified as a "non-qualified covered call" under IRS rules, the IRS suspends your holding period on the underlying shares for as long as that call is open. If you already cleared the 12-month threshold before writing the call, and the call qualifies under IRS guidelines, your long-term status is generally safe. The key is understanding what makes a covered call "qualified" versus "non-qualified."

What the IRS Actually Says: Straddle Rules and Section 1092

The IRS treats certain covered calls as part of a "straddle" — a position where you hold offsetting risk on the same stock. Under IRC Section 1092, if a covered call is deemed to create a straddle, the IRS can suspend your holding period on the underlying shares while the call is open. This means a stock you have held for 13 months could temporarily lose its long-term status if you write a call that the IRS considers non-qualified.

The IRS defines a "qualified covered call" in IRS Publication 550 and in the instructions tied to Section 1092. To be qualified, the call must meet several tests, the most important being the strike price test. In plain terms, the call cannot be too deep in the money. The IRS uses a tiered table based on the stock's closing price the day before you write the call. For stocks priced above $25, the lowest allowable strike is generally one strike increment below the stock's closing price — meaning slightly in-the-money calls can still qualify, but deep in-the-money calls will not.

If a call fails the qualified test, the IRS suspends your holding period from the day you write the call until the day you close or the call expires. If the call is open for three months and you then sell the stock, those three months do not count toward your holding period. For most investors who already have 12-plus months on the clock, this is a nuisance rather than a disaster — but it can matter if you are close to the one-year line.

Worked Example: AAPL Covered Call and Holding Period Risk

Say you bought 100 shares of Apple (AAPL) at $150 per share in January 2023. By February 2024 you have held them 13 months, so you have long-term status. AAPL is now trading at $182. You decide to sell one covered call contract.

Scenario A — Qualified Call: You sell the AAPL $185 call expiring in 45 days for a $3.20 premium ($320 total). The $185 strike is above the current price of $182, so this is an out-of-the-money call. It easily passes the IRS strike price test and is a qualified covered call. Your long-term holding period on the shares is not suspended. When the call expires worthless, you keep the $320 as short-term ordinary income (more on that below), and your shares remain long-term.

Scenario B — Non-Qualified Call: Instead, you sell the AAPL $160 call — deep in the money — for $23.50 ($2,350 total). The $160 strike is $22 below the current price of $182. This call fails the IRS strike price test and is a non-qualified covered call. The IRS suspends your holding period on your 100 AAPL shares for the entire time this call is open. If the call stays open for 60 days and you then sell the shares, those 60 days are erased from your holding period. Since you already had 13 months, you still clear 12 months — but if you had been at 11 months when you wrote it, you could end up short-term.

The practical takeaway: stick to at-the-money or out-of-the-money strikes, and you will almost never trigger the non-qualified rule.

How the Premium Itself Is Taxed

The premium you collect when you sell a covered call is not taxed when you receive it. The IRS requires you to wait until the position is closed before reporting it. There are three outcomes:

1. The call expires worthless. You report the full premium as a short-term capital gain in the tax year it expires, regardless of how long you held the underlying shares. Premium income from covered calls does not inherit the long-term status of the stock.

2. You buy the call back to close the position. You report the difference between what you sold it for and what you paid to close it as a short-term capital gain or loss.

3. The call is exercised and your shares are called away. The premium is added to the sale proceeds of the stock. The gain or loss on the stock itself — premium included — is then long-term or short-term depending on your holding period in the shares.

This is a point many traders miss: even if you have held AAPL for five years and sell a qualified covered call, the premium income itself is always short-term. Only the gain on the shares, if exercised, can be long-term.

The Risks You Need to Know Before Writing Calls on Long-Term Holdings

Tax risk is real and it deserves a direct discussion, not a footnote.

Holding period suspension is the biggest tax risk. As explained above, a non-qualified call freezes your clock. If you are sitting at 10 months and you write a deep in-the-money call that stays open for three months, you could sell the shares and owe short-term rates — which for many investors is 22% to 37% federal — instead of the 15% or 20% long-term rate. That difference on a large position can cost thousands of dollars.

Exercise risk is the second concern. If your call is exercised, your shares are sold at the strike price. You lose any upside above the strike, and you trigger a taxable event on the shares. If you were planning to hold those shares for years to defer taxes, an early exercise ends that plan.

Wash-sale and straddle interactions can also create complexity. If you close a covered call at a loss and buy a new one on the same stock shortly after, the IRS straddle rules may defer that loss. FINRA and the IRS both flag these situations in investor education materials as areas where retail investors frequently make errors.

Always consult a qualified tax professional before writing covered calls on shares with large embedded gains. The rules in IRS Publication 550 are detailed, and individual circumstances vary.

Canadian Investors: What the CRA Says

Canadian investors face a different framework. The Canada Revenue Agency does not use the same "qualified covered call" language as the IRS. Under CRA rules, options income is generally treated as either business income or capital gains depending on the frequency of your trading and your intent. If the CRA views your covered call activity as a business, all premiums — and potentially gains on the underlying shares — are taxed as fully included business income rather than at the 50% capital gains inclusion rate.

For buy-and-hold investors who write occasional covered calls on shares they own for investment purposes, the CRA typically treats the premium as a capital gain, reducing the adjusted cost base of the shares. However, if you write calls frequently, the CRA may reclassify your activity as a business. CRA Interpretation Bulletin IT-479R covers transactions in securities and is the primary guidance document. Canadian investors should speak with a Canadian tax advisor familiar with derivatives before writing covered calls on shares with large accrued gains.

Practical Rules to Protect Your Long-Term Status

You do not need to memorize every line of Section 1092 to trade safely. Follow these practical guidelines and you will avoid most problems.

First, write out-of-the-money or at-the-money calls. A strike at or above the current stock price almost always passes the IRS qualified covered call test. If MSFT is trading at $415, selling the $420 call is safe. Selling the $390 call is not.

Second, check your holding period before you write. If you are within 30 days of the 12-month mark, consider waiting until you have clearly crossed it before selling any call, even an out-of-the-money one. The risk of a mistake is highest when you are right on the line.

Third, track every call you write in a spreadsheet alongside the holding period of the underlying shares. Your broker's 1099 will show the option transactions, but it will not automatically flag holding period suspensions for you. That is your job, or your tax advisor's job.

Fourth, if you are writing calls on a position with a very large unrealized gain — say you bought NVDA at $120 and it is now at $900 — the tax stakes are high enough that a one-hour conversation with a CPA who understands derivatives is worth every dollar.

The Options Industry Council (OIC) offers free educational resources on covered call tax treatment that are a useful starting point before you talk to a professional.

Does selling a covered call reset my one-year holding period on shares I already own?

It can, but only if the call is classified as a non-qualified covered call under IRS Section 1092. If you sell an out-of-the-money or at-the-money call, it is almost always a qualified covered call and your holding period is not affected. Deep in-the-money calls are the main danger zone.

Is the premium I collect from a covered call taxed as long-term or short-term?

Premium income from covered calls is always taxed as a short-term capital gain, regardless of how long you have held the underlying shares. The IRS taxes the premium in the year the position closes — either through expiration, buyback, or exercise — and it never qualifies for long-term rates on its own.

What happens to my taxes if my covered call gets exercised and my shares are called away?

When your shares are called away, the premium you collected is added to the sale price of the stock. The total gain or loss on the shares — including the premium — is then long-term or short-term based on your holding period in the stock, not the option. If you held the shares over a year and the call was qualified, you pay long-term rates on the stock gain.

What is a qualified covered call according to the IRS?

A qualified covered call is one that meets the strike price and term requirements in IRS Publication 550 and IRC Section 1092. The most important test is that the strike price cannot be too far below the stock's current price — deep in-the-money calls fail this test. Calls that are at-the-money or out-of-the-money almost always qualify.

Do covered call rules work the same way in Canada as in the United States?

No. The CRA does not use the qualified covered call framework that the IRS uses. In Canada, premiums from covered calls are generally treated as capital gains for buy-and-hold investors, but frequent trading can cause the CRA to reclassify all activity as business income. CRA Interpretation Bulletin IT-479R is the key guidance document, and Canadian investors should consult a tax advisor familiar with derivatives.

Can I write covered calls inside a Roth IRA or TFSA to avoid the tax issues?

Writing covered calls inside a Roth IRA eliminates US federal income tax on the premium and any stock gains, since qualified distributions from a Roth are tax-free. In Canada, covered calls inside a TFSA are generally tax-sheltered, but the CRA may treat frequent option writing as business income even inside a TFSA. Check with your broker and a tax advisor before trading options in registered accounts.