on concentrated single-asset positions (book 1 of shewser notes, p.367):
it says:
“Many tax codes treat employer stock options as an alternative to salary and tax any gains on the options as ordinary income. Hedging the options could produce a mismatch in character. As an example, a gain on stock options of $100,000 is taxed as ordinary income at 30%, while offsetting losses of $100,000 on the derivatives hedge are used to reduce long-term gains that are taxed at 10%. The tax of $30,000 is reduced by only $10,000 of capital gains tax not paid and only if the investor has $100,000 of capital gains to shelter.”
so we have the stock options and the derivatives hedge here.
what does it mean by: are used to reduce long-term gains that are taxed at 10%?
also, what does it mean by: only if the investor has $100,000 of capital gains to shelter?
stock options are treated like ordinary income. So a capital gains of 100000$ is taxed at 30% -> causing taxes of 30000$. (current period capital gains tax).
if you used regular options and they encountered loss- you get a 10% LONG TERM LOSS (beyond current period) of 10000$- and this would occur only if there were 100000$ of loss available to you.
hope this makes it clear.
100000$ gain on stock options = 30000 capital gains tax immediately.
if you had 100000$ on derivatives available to you - you would get an offsetting amount of long term loss of 10000$ (due to the lower offsetting tax loss rate). Additionally - given that these were long term - and the various individual biases - you are unlikely to have that much of a loss accumulation in your portfolio. (An investor would be unlikely to keep such a loss making position in the portfolio).
there is a mismatch in character and timing between the loss making position and the gain making positions.
you can offset capital gains by capital losses on your tax statement. (Shelter provided by capital losses).
For the capital loss tax to be available to you - you need them to be available in the same period. Also due to the differing tax rates applicable - the amount of capital losses would need to be MUCH higher than the capital gains to be able to provide some sort of relief.
to have 100,000$ of capital gains to offset [this offset is on the taxes due to the gains] - due to the differing tax rates - he would need (in your case 10% = loss rate, 30% = gains rate).
100000 * 0.3 (Tax on gains ) / 0.1 (Tax Rate on losses) = 300,000 of losses.
so not paid means like: the long-term loss position would have been used to pay long-term agains already. so the loss can only be used to offset the tax on the stock option only if it has not been used to pay the long-term gains?
the timing of the gains and losses are also not the same.
you are getting a capital gains tax today. however only if you had a big loss making position already available to you - and you sell it now - can you offset the position right away. You cannot offset something now with something that is expected to make a loss in the future.
additionally - if you used the loss making position once, it is gone. - but your stock option making a gain - is by the nature of the beast - expected to continue to make profits for you (the investor) into the foreseeable future.
so the timing of the losses on the derivatives hedge is the same as the timing of the capital gains.
so when you incur long-term capital gains, the losses on the derivatives hedge would have been used to offset the gains.
that is why when you have the gains on the options, you wouldnt have the loss to offset the option gains (cause the losses have been used to offset the long-term gains already)
possibly i am getting confused. Maybe you are saying the same as I am.
there are two pieces.
Stock options - you have a gain - but these are short term gains taxed at 30%.
Regular hedge options - you have a loss - but these are long term, and provide you tax relief at 10%.
if the long term loss has to be applied towards the short term gain - you need to have enough accumulated losses to offset - otherwise the amount of taxes you pay would be high.
say you have enough losses accumulated - due to whatever reason - and you use them now - they will not be available to use in a future period. (So your tax loss savings are a one time application) - however by the nature of the stock options - being what they are - they will continue to provide you gains year after year.
in addition - the timing of when to take the “loss” is also something to be considered. Say you expect taxes to increase to 40% 2 years from now - does it make sense to pay 30000$ now, and take the tax loss 2 years from now? If the tax rate hike does not materialize - will you the investor face “regret”?
today tax rates are 30% on the capital gains. you had 10K worth of tax losses available to you and you used it. so you paid net taxes of 20K .
however - say there were a couple of other things you knew about … (expectation that tax rates would go up to 40% in a couple of years).
would you have preferred to have the 10K $ available as losses to apply then? yes you would. so you decide to postpone declaring losses now - to make it available to you to pay lower net taxes at a future date.
now say the 40% tax does not materialize - at that time - would you have regrets that you did not take the loss available before itself?