Taxes and Derivatives: An Investor’s Perspective

Abstract

In this article, we cover the basics of how derivatives currently are taxed and the key considerations of which investors and portfolio managers should be aware, such as wash sales, tax straddles, and constructive sales. We also highlight an example of how derivatives can be used to tax-efficiently hedge and monetize a concentrated stock position. Often, articles addressing taxation focus on nuance and the specific cases in which exceptions apply. In this article, we seek clarity over completeness. Our goal is to summarize the tax rules for derivatives in a way that is accessible to investors and investment professionals. We limit our discussion to securities products, not other sorts of investments, and to those taxpayers that are classified as investors, not dealers or business hedgers. The piecemeal nature of the US tax law with respect to derivatives creates complications for portfolio managers. Some trades are taxed more heavily than others, which emphasizes the need for careful tax consideration when using derivatives.