Tax Treatment on Options Trading & Special Tax Treatment
Special tax treatments for options
An essential component of being a good investor is understanding the taxes involved with buying and selling securities. Sometimes taxes can be as straightforward as paying the tax on capital gains and deducting losses from your taxable income. However, options can be a little more complicated.
Differences between stocks and options
Taxation of stocks is relatively simple. When you sell a stock at a gain, you will pay capital gains tax on it, and if you sell it at a loss then you can deduct it against your taxable income.
Due to the complex nature of options, there are many nuances to the tax rules that traders should familiarize themselves with to implement efficient financial plans and file their taxes correctly.
Short-term vs. long-term
Capital gains/losses are broken into two categories, long-term and short-term. Long-term tax rates are usually substantially lower than short-term capital gains tax rates.
The rule of thumb for long-term capital gains is that a security must be held for 365 days at least before the trader takes a profit or a loss on it.
The length of time that a trader owns a security is referred to as the holding period. The holding period is used to determine whether a gain or loss is long or short-term. Under normal circumstances, the date that an option contract is purchased is the date used to start the holding period. There are a couple of exceptions that can change or offset the start date, such as trading covered calls and the Wash Sale Rule.
When a trader sells a call contract and simultaneously own shares of the stock that the contract represents, it is called a covered call.
Determining the tax for at-the-money and out-of-the-money covered calls depends on whether the call is unexercised, the call is exercised, or the call is bought back to close the position.
As an example, let’s say that Dave owns 100 shares of XYZ Corp, which is trading at $50, and he sells a $60 call for XYZ that expires in October at a $1.05 premium.
Option is not exercised
October rolls around, and XYZ is trading at $52. The call is not exercised, and Dave will net a short-term gain of $1.05 per share on the call he wrote.
Option is exercised
If the option is exercised, Dave will realize a capital gain on his shares of XYZ that is calculated off his total cost over the time he owned the shares. If he bought the shares last February at $40, his gain would be $21.05/share ($60 strike price – $38.95 price paid minus premium).
The option is bought to close
Dave decides to close his open call position by buying the contract back. The tax calculation is subject to what price he paid to purchase it back. If he spent less than he sold it for, he would record a capital gain, and if he paid more than he sold it for, he would record a loss.
In-the-money covered calls
The tax rules for covered calls that expire in the money are more complicated. They depend on whether the call is qualified or unqualified. Qualified covered calls can be taxed at long-term capital gains rates, while unqualified trades are taxed at short-term capital gains rates – regardless of how long the shares are held.
Determining whether a call is qualified or not is an intricate process, and more specific information can be found at the IRS website linked at the bottom of this page.
As a general rule, the call should not be lower than the previous day’s closing price, and it must have more than 30 days left until it expires.
Wash sale rule
The wash sale rule prevents losses in particular security from being transferred to a “substantially identical” security with a 30-day window.
If we look back at Dave, he could not take a loss on his XYZ stock, and immediately purchase a call option on XYZ within 30 days. The loss would not be allowed; rather, it would be added to the premium he paid for the new call option.
In this example, Dave’s holding period for the call option would start on the day he sold the shares of XYZ, not the day that he purchased the call.
When a trader purchases an option, either a call or a put, there is a stated expiration date unless the trader decides to roll it forward.
If the option expires at a profit, then the rules are similar to selling an option: if the option was held for less than a year, then it will be considered a short-term gain. If the option was held for more than a year, then it would be considered long-term.
It is important to note that if an option seller buys back the option to close out the position before it expires, then the resulting gain or loss is automatically treated as short-term. This rule applies even if the option was sold more than a year ago.
Option exercises and stock assignments
When an option is exercised, the trader does not report the position on Schedule D Form 8949. Instead, the option’s premium is either added or subtracted to the overall cost basis of the stock. The IRS applies different rules depending on whether it is a call or a put to determine how the premium is treated.
When a call is exercised, the holder purchases shares from the writer at the strike price. The holder adds the premium from the cost basis of the shares, and the writer includes the premium and increases the realized amount on the sale of the shares.
Let’s look at a hypothetical example:
Hannah purchased a call for ABC Inc. with a $100 strike price at a $2.00 premium that expires in six months. ABC is currently trading at $83. after Hannah purchases the option, ABC releases earnings and exceeds analyst predictions causing the stock to shoot to $112.
Since the option is now in-the-money, Hannah would like to exercise her option and purchase the shares of ABC. Her cost basis would be $10,200 ($100 strike price x 100 shares + $200 premium).
If she sells the shares three months later at $120, she will have realized a $20 gain per share ($120 market price – $100 strike price)
Since this trade was completed under a year, it would be considered a short-term capital gain, and Hannah would have to pay taxes accordingly.
Puts are treated similarly to calls, but if the option is exercised without the trader owning the shares, then the trade could be taxed under short-sale rules. These would calculate the total time starting at the exercise date to the closing date.
If a put is exercised, the holder reduces the amount realized from the sale of the shares by the price of the premium, and the writer reduces the cost basis of the stock received.
Benefits of exchange-traded/broad-based Indexed options
The IRS treats the sale of exchange-traded index options and other non-equity securities such as bonds or commodities, differently than other types of options transactions.
The 60/40 rule
In this case, the IRS rules can be quite favorable to traders due to the 60/40 rule. Under the 60/40 rule, 60% of gains are treated as long-term, and 40% are treated as short-term, regardless of the holding period.
Among the benefits of this rule are lower capital gains taxes. Since the holding period on the security does not influence the tax rate, the majority of capital gains from exchange-traded indexed options will be taxed at long-term rates, which have a maximum of 23.8%. Under the 60/40 rule, the short-term capital gains rate can reach as high as 43.4%, which enhances the benefit of the rule.
Other securities that fall under the 60/40 rule when held for less than a year include regulated futures and foreign currency contracts as well as non-equity, debt, commodity futures, and currency options.
At the end of the year, the IRS considers these contracts as marked to market (MTM) at their fair value. This MTM valuation treats them as if they were closed. Holding the securities longer will incur higher capital gains taxes.
As you can see, there is quite a bit of nuance when it comes to the tax treatment of options. While taxes are not fun, misfiling or misunderstanding, the tax implications of trades is much worse.
Fortunately, there is plenty of information on why options are taxed, and what rules are in place to assist traders.
By taking the time to research and understand the difference between short and long-term capital gains, how expiration can affect your taxes, and more, you will be in a much better position to plan out your trades.
For more information on special tax rules that apply when selling options, see IRS Publication 550 https://www.irs.gov/pub/irs-pdf/p550.pdf, page 60.
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How are options taxed when exercised?
When an options contract is exercised, the IRS has specific rules about handling the cost basis of the new position. These rules differ depending on if a put or call option is exercised. The direction in which the cost basis is adjusted depends on whether the account holder is the buyer or seller and whether the contract is a call option or put option.
If the account holder is a buyer of a call option and chooses to exercise the option, add the cost of the call option to the cost basis of the stock purchased. For example, Sally buys a call option for $2 for ABC stock with a $50 strike price. If she exercises the option to buy ABC stock at $50, the cost basis in ABC is $50 + $2 = $52. The holding period for stock acquired when exercising an option begins the day after the option is exercised.
If the account owner is a buyer of a put option and chooses to exercise the option, subtract the put option’s cost from the amount realized on the exercise. For example, Bob buys a put option for $2 for ABC stock with a $50 strike price. If he exercises the option to sell ABC stock at $50, the amount realized on ABC’s sale is $50 - $2 = $48.
The IRS treats buying a put option as a short sale. The exercise, sale, or expiration of the put is a closing of the short sale. If the account holder has a long stock position and buys a put option, the holding period for capital gains or losses is dependent on how long the long stock position was held. For example, if Sue has held 100 shares of ABC stock for 6-months and buys and exercises a put option with a $50 strike, any gain on the exercise, sale, or expiration of the put is a short-term capital gain.
If the account owner sells a call or put, the premium received is a short-term capital gain. The account owner does not realize the gain until either the trade is closed or the option expires. If the put option sold is exercised and the owner is assigned stock, subtract the cost basis of the exercised stock by the amount of premium received. For example, Bob sells a put option on ABC stock for $2 with a $50 strike price. Bob is assigned ABC stock at $50. Bob’s cost basis in ABC stock is $50 - $2 = $48. His holding period in ABC stock begins on the date he was assigned and bought the stock, not the date he originally sold the put.
If a call option sold is exercised and the account owner is assigned stock, the amount realized on the sale of the stock is increased by the amount received in call option premium. For example, Sue sells a call option on ABC stock for $2 with a $50 strike price. The amount Sue realizes on the sale of the ABC stock position is $50 + $2 = $52. Her capital gain or loss is based on the $52 realized amount. The gain or loss on the ABC position is based on how long she holds ABC stock. If the holding period is longer than one year, the gain is considered long-term.
Unlike option sales and expirations, the option position is not reported on Schedule D Form 8949 when exercise or assignment happens. Instead, the proceeds from the sale of the option are included in the stock position from the assignment.
When calculating the tax liability, properly adjust the cost basis of stock to make sure the option premium is incorporated in the stock position’s cost basis.
How do I report options trading on my tax return?
Profits or losses from trading equity options are considered capital gains or losses (these get reported on IRS Schedule D, Form 8949).