In the Money Covered Call Tax Implications: What Every Seller Needs to Know

The Short Answer: ITM Covered Calls Can Trigger Unexpected Tax Bills

Selling an in-the-money (ITM) covered call does not just generate premium income — it can reset your stock's holding period, convert a long-term gain into a short-term one, and strip away the qualified-dividend status on any dividends you collect while the call is open. The IRS treats ITM covered calls as "unqualified covered calls" under Section 1092 of the Internal Revenue Code, which suspends your holding period clock for as long as the call is outstanding. Understanding these rules before you sell can save you a meaningful amount of money at tax time.

What Makes a Covered Call 'In the Money' for Tax Purposes?

A covered call is in the money when its strike price is below the current market price of the stock you own. If you own 100 shares of AAPL trading at $195 and you sell a $190 strike call, that call is $5 in the money.

But the IRS goes further than just checking the strike versus the current price. Under IRS Publication 550 and the rules codified in IRC Section 1092, a covered call is considered "qualified" — meaning it does NOT suspend your holding period — only if it meets specific strike-price tests relative to the stock's closing price on the day before you sell the call. The IRS defines the lowest acceptable strike for a qualified covered call based on the stock's price and the option's time to expiration. In plain terms: the deeper in the money your call is, the more likely it is to be classified as unqualified, triggering the holding-period suspension rules.

For options with more than 30 days to expiration, the IRS generally allows the strike to be one strike increment below the stock's prior-day closing price and still be considered qualified. Anything deeper than that is unqualified. For shorter-dated options, the rules tighten further. Always verify the current thresholds in IRS Publication 550 or with a tax professional, because the exact tables depend on the stock's price tier.

How the Holding Period Suspension Actually Works

Here is the core risk most retail traders miss. Suppose you bought 100 shares of MSFT at $320 eleven months ago. The stock is now at $415. You are one month away from the one-year mark that would make your gain long-term (taxed at 0%, 15%, or 20% depending on your income). You decide to sell a $410 strike call — which is $5 in the money — to collect a fat premium.

Because that call is unqualified under IRC Section 1092, the IRS pauses your holding period clock the moment you sell it. Your eleven months of holding time stops accumulating. If you close the call or get assigned within that one month, you never reach the one-year threshold. Your entire gain on MSFT — potentially tens of thousands of dollars — gets taxed as short-term capital gains, which are taxed at your ordinary income rate, not the preferential long-term rate.

The holding period resumes only after the unqualified call is closed, expires, or results in assignment. If the call expires worthless and you still hold the stock, your holding period clock starts ticking again from where it left off — but the time the call was open does not count.

This is not a minor technicality. For a trader in the 32% federal bracket holding a $20,000 gain, the difference between long-term (15%) and short-term (32%) treatment is $3,400 in extra federal taxes on that one position alone.

Worked Example: AAPL ITM Covered Call Tax Math

Let's run the numbers with a concrete example.

**Setup:** - You bought 100 shares of AAPL at $150 per share on January 15, 2024. - Today is December 10, 2024. AAPL is trading at $230. Your unrealized gain is $8,000. - You sell one AAPL January 17, 2025 $225 call (ITM by $5) for $9.50 per share, collecting $950 in premium. - January 15, 2025 would be your one-year anniversary — making your gain long-term.

**What happens if you get assigned on January 17, 2025:** - Your shares are called away at $225. Total proceeds: $22,500 + $950 premium = $23,450. - Your cost basis: $15,000. - Your gain: $8,450. - Because the $225 call was unqualified (ITM) and your holding period was suspended while the call was open, you do NOT hit the one-year mark. The gain is short-term. - At a 32% federal rate: tax owed ≈ $2,704. - If the call had been out-of-the-money and qualified, the gain would be long-term. At 15%: tax owed ≈ $1,268. - **Extra tax cost from selling ITM: approximately $1,436 on this single trade.**

**What happens if the call expires worthless:** - You keep the $950 premium. That premium is taxed as short-term capital gain in the year you collected it, per IRS Publication 550. - Your AAPL holding period resumes, but the 37 days the call was open do not count. You need to hold the stock for additional time to reach one year.

The lesson: the $950 premium looked attractive, but the potential tax cost of converting a long-term gain to short-term was larger than the premium itself.

Qualified Dividends: The Hidden Second Risk

There is a second tax hit that often surprises traders. To receive qualified dividend treatment (taxed at 0%–20% rather than ordinary income rates), the IRS requires you to hold the stock for more than 60 days during the 121-day window centered on the ex-dividend date. Selling an unqualified ITM covered call suspends your holding period, which means those days do not count toward the 60-day qualified-dividend requirement.

If AAPL pays a dividend while your unqualified ITM call is open, that dividend may be reclassified as ordinary income rather than a qualified dividend. For investors who own dividend-paying stocks specifically for the tax-advantaged income, this is a real cost that compounds over time.

The IRS details these rules in Publication 550 under the section on options. FINRA also flags holding-period suspension as a key risk factor in its investor education materials on covered calls.

Canadian Investors: How the CRA Treats ITM Covered Calls

If you are a Canadian investor, the Canada Revenue Agency (CRA) does not have a direct equivalent to the IRS's Section 1092 unqualified-covered-call rules. However, the CRA has its own framework that can affect how covered-call premiums and assignment proceeds are taxed.

Under CRA guidance, the premium you receive from selling a covered call is generally treated as a capital gain — not income — at the time the option expires or is closed. If the call is exercised and your shares are called away, the premium is added to the proceeds of disposition for the shares, which affects your capital gain calculation.

However, if the CRA determines you are trading options as a business (based on frequency, intent, and other factors), all gains — including premiums — may be taxed as fully-included business income rather than at the 50% capital-gains inclusion rate. Selling deep ITM covered calls repeatedly can be one of the patterns the CRA examines when assessing whether activity crosses from investing into business income. Consult a Canadian tax professional familiar with CRA's IT-479R interpretation bulletin on transactions in securities.

How to Manage the Tax Risk Without Giving Up Income

The goal is not to avoid covered calls — it is to sell them in a way that does not accidentally hand the IRS a larger check than necessary. Here are practical steps.

**Check your holding period first.** Before selling any covered call, know exactly how many days you have held the stock. If you are within 30 days of the one-year mark, selling an ITM call is almost never worth the tax cost.

**Stick to at-the-money or out-of-the-money calls when holding period matters.** OTM and ATM calls that meet the IRS's qualified-call strike tests do not suspend your holding period. You collect less premium, but you protect your long-term tax status.

**Use ITM calls freely in tax-advantaged accounts.** Inside a traditional IRA, Roth IRA, or Canadian TFSA/RRSP, the holding-period suspension rules are irrelevant because gains are either tax-deferred or tax-free. Selling deep ITM calls for maximum premium makes much more sense in these accounts.

**Track every open call against its stock's holding period.** A simple spreadsheet with columns for purchase date, current holding days, call strike, and call expiration date is enough. Many brokerage platforms also display holding period data directly in the tax-lot view.

**Talk to a tax professional before year-end.** If you have open ITM calls heading into December, a tax advisor can help you decide whether to close them before December 31 to manage your tax year, or hold through expiration. The Options Industry Council (OIC) also offers free educational resources on the tax treatment of options that are worth reviewing.

Honest Risk Summary: What Can Go Wrong

Selling ITM covered calls is not inherently bad — but the risks are real and specific.

**Tax risk:** As shown above, holding-period suspension can convert a long-term gain into a short-term one, costing thousands of dollars in extra taxes on a single position.

**Upside cap risk:** When you sell an ITM call, you cap your upside at the strike price. If AAPL jumps from $230 to $260 before expiration, you still get called away at $225. You miss $35 per share of upside.

**Early assignment risk:** American-style equity options can be assigned at any time before expiration. Deep ITM calls have a higher probability of early assignment, especially around ex-dividend dates. If you are assigned early, your holding period ends immediately — which may or may not be what you planned.

**Premium does not always compensate:** The extra premium from selling ITM versus ATM can look large in dollar terms but small relative to the tax cost and the upside you surrender. Always run the after-tax math, not just the gross premium.

The SEC's Office of Investor Education and Advocacy recommends that investors understand all costs — including tax costs — before entering options strategies. That advice applies directly here.

Does selling an in the money covered call reset my holding period?

Yes, if the call is classified as an unqualified covered call under IRC Section 1092, the IRS suspends your holding period for as long as the call is open. The clock does not reset to zero — it simply stops running until the call is closed, expires, or results in assignment. Days when the unqualified call was open do not count toward the one-year threshold for long-term capital gains treatment.

How does the IRS decide if a covered call is 'qualified' or 'unqualified'?

The IRS uses a strike-price test described in IRS Publication 550 and IRC Section 1092. In general, a covered call is qualified if the strike is not more than one increment below the stock's closing price on the prior trading day, though the exact threshold depends on the stock's price tier and the option's time to expiration. Calls with strikes deeper in the money than the allowed threshold are unqualified, triggering the holding-period suspension rules. Always check Publication 550 or consult a tax professional for the current tables.

What happens to my covered call premium at tax time?

Under IRS Publication 550, the premium you receive from selling a covered call is not taxed when you collect it. If the call expires worthless, the premium is reported as a short-term capital gain in the year of expiration. If the call is exercised and your shares are called away, the premium is added to your sale proceeds and the entire gain or loss is calculated at that point.

Can selling an ITM covered call affect my qualified dividend income?

Yes. To receive qualified dividend tax rates, the IRS requires you to hold the stock for more than 60 days in the 121-day window around the ex-dividend date. Because an unqualified ITM covered call suspends your holding period, those days do not count toward the 60-day requirement. Dividends received while an unqualified call is open may be reclassified as ordinary income, as explained in IRS Publication 550.

Are ITM covered calls taxed differently inside an IRA or TFSA?

Inside a traditional IRA or Roth IRA, capital gains and holding-period rules do not apply in the same way because the account is tax-deferred or tax-free — so the holding-period suspension from an unqualified ITM call is irrelevant. Canadian investors using a TFSA or RRSP similarly avoid the CRA capital-gains implications on covered-call premiums within those registered accounts. This makes tax-advantaged accounts an ideal place to use more aggressive ITM covered-call strategies.

How does the CRA treat covered call premiums for Canadian investors?

The CRA generally treats covered-call premiums as capital gains — taxed at the 50% inclusion rate — when the option expires or is closed, and adds the premium to sale proceeds if the shares are called away. However, if the CRA determines your options activity constitutes a business rather than investing, all premiums may be taxed as fully-included business income. CRA's IT-479R interpretation bulletin on securities transactions provides further guidance, and a Canadian tax professional can help you assess your specific situation.