Ah, taxes, a dreaded but necessary part of investing and trading. Although you might be inclined to skip this week’s show, I’d encourage you to dive in because, even for me personally, this discussion helped clarify and re-solidify mildly opaque concepts. Plus, I brought in a special guest to help chat through the different sections, and I know you’re going to love this episode on taxes for options trading.

• Tax concepts and terminology can get complicated fast. The tax code is voluminous. There are loopholes, pitfalls, rules, and exceptions. Our goal today is to help educate you by explaining some of them. We are introducing some basic education concepts to ease the worry and anxiety around taxes and trading and to try to put some more tools in your toolbox.
• We brought in a special guest to help with this, one of the newest members of our team, Ryan, who is responsible for the new Option Alpha Handbook!
• The Option Alpha Handbook explains all of the concepts that we dive into on this show!

Foundational Tax Terms That Are Important to Know

Earned Income

• Includes wages, salaries, tips, and net earnings from self-employment. This is often the type of income for which a W-2 or a Form 1099 for self-employment income is received. Earned income may result from wages received or from owning and operating a business.

Interest Income

• The income received from certain bank accounts, such as savings or money market accounts, or investments such as corporate bonds, municipal bonds, Treasury securities, and other investments. Form 1099-INT from brokerage firms, mutual funds, and other financial institutions is distributed for accounts with interest income of more than $10 during the year.

Dividend Income

• Distributions of money, stock, or other property paid to a shareholder by a corporation, ETF, or mutual fund. Dividends are reported on Form 1099-DIV for taxable accounts and are primarily separated by ordinary dividends and qualified dividends.

Capital Gains

• A capital gain is an increase in the value of an asset that gives it a higher worth than the purchase price. There are short-term capital gains and long-term capital gains. Short-term refers to a holding period of less than a year, and long-term refers to a holding period of more than a year. Depending on how long you hold the investment, you’ll be taxed at a different tax bracket. Short term capital gains are taxed at the same tax rate as your ordinary income. Long term capital gains are taxed at the capital gains rates. Those are based on your income and your filing status.

Wash Sale

• A wash sale occurs when a security is sold or traded at a loss and, within 30 days of the sale, substantially identical securities are purchased. The wash sale rule was designed to discourage investors from selling securities at a loss simply to claim a tax benefit and immediately repurchasing the security. If a sale is classified as a wash-sale, the loss is not allowed and is added to the cost basis of the repurchased securities. Wash sale rules apply across accounts, including accounts held at different brokerage firms.
• When you think about a wash sale, just think that you are deferring your loss until you’ve ultimately closed the position.

Example of a Wash Sale:

• On June 1st, you sell XYZ stock at $200 for a $50 loss. Originally, you purchased stock at $250, now you sell it at $200 for a $50 loss. 15 days later, you repurchase shares of XYZ at $205. Now the shares have gone up 5 bucks. Because you repurchased the shares within 30 days of the first transaction, the cost basis for the shares purchased 15 days later is adjusted higher, not $205, where he purchased them now, but to $255. The trick is to understand that we have to adjust the cost basis. In this case, you repurchased shares within 30 days, so you add the $5 cost basis to the $50 loss.
• The wash sale adjustment essentially postpones that $50 loss until the new purchase, the $205 purchase, is sold.

Substantially Identical Securities

• A substantially identical security is a security that resembles the original purchase.
• What is a “substantially identical stock or security?” The definition of “substantially identical stock or securities” is up for interpretation. On page 56 of IRS Publication 550, the IRS describes “substantially identical” in this way:
• In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stock or securities of one corporation are not considered substantially identical to stock or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.
• Selling stock for a loss and then buying a call option on the same security is likely to trigger a wash sale because acquiring “a contract or option to buy substantially identical stock or securities” is explicitly described by the IRS as a reason for a wash sale.

Taxes on Options

• Taxes on stocks are straightforward: The stock goes up. If you hold it for less than a year, you have a short-term capital gain. If you hold it for more than a year, you have a long-term capital gain, etc.
• When it comes to taxes on options, though, it’s important to consider what your strategy is, because taxes for selling options look a little bit different than taxes when buying options.

Taxes When Buying Options

• As with stocks, profits or losses from trading equity options are considered capital gains or losses (these get reported on IRS Schedule D, Form 8949). For example, if you purchased a call option for $3 to buy XYZ, and XYZ subsequently rallies and the value of the call option increases to $5, and you sell the call option for $5, you have a $2 capital gain on the trade. The length of time holding the option before selling determines whether it was a short-term or long-term capital gain/loss.

Taxes When Selling Options

• Things change if you are an option seller. If an option is sold, you’ve got a couple of different scenarios whenever the position is closed.
• The value of that option can go down, and you buy it back and close that for a profit. If you buy back the contract early, you get short-term capital gains no matter what.

Example of Buying Back the Contract Early:

• If an option is sold (also known as writing an option), the gain or loss reported depends on whether the option was exercised. If the account owner sells an option and then buys it back for less money before expiration, the profit received is a short-term capital gain.
• If you sell an option and close that contract out, regardless of how long that position was open, you’re looking at a short-term capital gain or loss.

Example of the Option Expiring Worthless:

• If the account owner sells an option and the option is not exercised and expires worthless, the premium received is a short-term capital gain. When an option seller buys back the option before expiration, the IRS considers the capital gain/loss as short-term regardless of how long the seller held the option.
• You sell a contract for $5, and you receive $500 of premium. The option expires worthless. The contract is considered closed at zero dollars. For holding period purposes, if you are the option seller, it’s a short-term capital gain, even though it expired worthless.
• If a buyer holds the option for 365 days or less before it expires, it’s a gain or loss in the short-term. If the option is held longer than 365 days, it’s a long-term for the buyer. For the seller, it’s always a short-term capital gain.

Options Expiration

• When a stock option expires, the trade is closed. The buyer and seller determine their gain or loss by subtracting the option purchase price from the sales price. The rule governing the short- or long-term capital gain designation is essentially the same as selling or buying back an option. If the option buyer held the position for less than a year, the gain or loss is long-term capital gain or loss. For an option seller, the gain or loss is a short-term capital gain or loss.

Option Exercises and Stock Assignment

• When an options contract is exercised, the IRS has specific rules about handling the new position’s cost basis.
• These rules differ depending on if a put or call option gets 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.

An Exercised Call Option

• If the account holder is a buyer of a call option and chooses to exercise the option, add the call option’s cost 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.

An Exercised Put Option

• If the account owner is a buyer of a put option and chooses to exercise the option, subtract the cost of the put option 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 Put Option Contract as a Short Sale

• 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 you held 100 shares of ABC stock for 6-months and buy 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.
• The idea here is that the put option is in conjunction with the long stock position. The holding period is dependent on how long the long stock position was held. That’s when you’re the put option buyer.

The Call Option Contract

• Suppose a call option sold is exercised, and the account owner is assigned stock. In that case, the amount realized on the sale of the stock is increased by the amount received in call option premium.
• For example, you sell a call option on ABC stock for $2 with a $50 strike price. The amount you realize on the sale of the ABC stock position is $50 + $2 = $52. Your capital gain or loss is based on the $52 realized amount. The gain or loss on the ABC position is based on how long you hold ABC stock. If the holding period is longer than one year, the gain is considered long-term.

A Note on Holding Periods on Exercised Positions:

• When you deal with holding periods, it really has to deal mostly with when the conversion happens to the stock. Whether it’s a call option, or whether it’s a put option, the holding period starts when you have the conversion to physical shares. Otherwise, it’s going to be taxed as short-term gains, because you’re just buying and selling the contracts back and forth.

IRS Reference

• The IRS provides a table on page 58 of Publication 550 summarizing the rules surrounding exercise and the expiration of options contracts. The table is fairly straightforward and provides a roadmap of the tax consequences of exercise and expiration.

Multi-Leg Positions

A Note on Straddles:

• The IRS definition of the word “straddle” is different than the meaning typically used in the options community. In option strategy terms, the combination of a put and a call with the same strike price and same expiration, typically at the money, is considered a straddle. The IRS considers “any set of offsetting positions on personal property” to be a straddle. An offsetting position is a position that substantially reduces any risk of loss by holding another position. For example, according to the IRS, a straddle may be a multi-legged strategy such as an iron condor, iron butterfly, or credit spread.

Off-Setting Positions

• The account owner can deduct a loss on the sale of a straddle only to the extent the loss is more than any unrecognized gain from an offsetting position. For example, you enter a credit spread for a $2 credit by selling a call option for $10 and buying a call option at a higher strike for $8. The next month, you close the credit spread for $1, resulting in a net profit of $1. The gain on the closing of the short call position (the one he sold for $10) is offset by the loss on the long call position (the one you sold for $8).

Straddles in a Wash Sale Scenario

• The account owner cannot deduct a loss on the sale of a straddle if, within 30 days before the sale and 30 days after the sale, the account owner acquires substantially identical stock or securities. For example, a TSLA stock position, a TSLA call option, and a TSLA call option with a different expiration date or strike price are all “substantially identical positions.” If a position such as an iron butterfly is rolled or adjusted, the loss on the sale of the straddle is deferred if a “successor position” was entered. A successor position is a position that is or was at any time offsetting to a second position–which would be the case if the iron butterfly was rolled from August to September, for example. Successor positions can be looked at as replacement stock. The account owner replaced the August iron butterfly with the September iron butterfly.
• So, if an iron butterfly is rolled or adjusted from August to September and another adjustment is made from September to October, a wash sale is triggered, and the losses accumulate and are deferred until the position is closed and the 30 day window that triggers a wash sale passes. The gain or loss from the iron butterfly is totaled across the positions from August to October to determine the total gain or loss on the position.

1256 Contracts

• These usually get a lot of attention but are largely dependent upon capital gains tax rates and have gotten less recently due to tax rates and capital gains rates having gone down slightly.
• Under Section 1256 of the Tax Code, certain investments are subject to favorable tax treatment. Equity options refer to options on individual companies and most ETFs. Section 1256 contracts are considered non-equity options. Section 1256 contracts include various investments defined by the IRS, such as regulated futures contracts and non-equity options. Non-equity options are listed options such as debt options, commodity futures options, currency options, and broad-based stock index options. Broad-based stock indexes are stock index futures made up of 10 or more underlying securities. Broad-based indexes are taxed differently than ETFs, which are considered securities. For example, SPX is listed on a commodities exchange and taxed as a Section 1256 contract. SPY is listed on a securities exchange and taxed as a security.
• Examples of contracts that may be eligible for Section 1256 tax treatment include SPX options, XSP options, RUT index options, and VIX index options. What makes this designation unique is that, for tax purposes, these contracts are marked to market at the end of the year and treated as sold at fair market value.
• Gains or losses are treated as a mixture of short-term and long-term capital gains. Gains and losses for Section 1256 investments are reported on Form 6781, and 60% of the gain or loss is taxed at long-term rates and 40% is taxed at short-term rates, no matter how long the security was held. The highest tax rate in the U.S. is reserved for ordinary income (wages), dividends, and short-term capital gains. A short-term capital gain is a realized trading profit from an investment held one year or less. Because of the blended tax rate for Section 1256 contracts, these contracts offer a significant tax advantage.

Section 1256 Example

• Consider an example of two traders in the top income tax bracket. Assume XSP options are subject to Section 1256 tax treatment, and SPY options are not.
• The first trader, Trader A, makes $100,000 in profit trading SPY options. Trader A is subject to a 37% short-term capital gains rate and 20% long-term capital gains rate. Trader A’s after-tax return is $100,000 x (1 – 0.37) = $63,000.
• Trader B makes $100,000 in profit trading XSP options. XSP options are similar to SPY options, but XSP options fall under Section 1256 of the tax code and have a tax advantage because they are based on the mini-SPX index. Futures contracts are classified as Section 1256 contracts under the U.S. tax code. Section 1256 contracts are taxed in a hybrid form, with 60% assumed to be at the lower long-term capital gains tax rate and 40% assumed to be at the higher short-term rate. This 60/40 split is applied regardless of the actual holding period of the futures contract. The effective tax rate for a futures contract can then be found as a function of the ordinary tax rate and the long-term tax rate. So, for Trader B, the blended tax rate for the XSP profits is (0.60 x 20%)+ (0.40 x 37%) = 26.8%. Trader B’s after-tax profit is $100,000 x (1 – .268) = $73,200.
• Consider the two traders in our example, each earned $100,000 in trading profit. If this profit had been earned trading XSP options instead of SPY options, the after-tax profit would have been $73,200, which is over 16% more than the $63,000 after-tax profit trading SPY options. Section 1256 contracts offer significant tax savings and can often be used to express the same trade ideas as typical securities options.

A Final Note on Taxes

• There are many moving parts to taxes, so how can we think about what we have learned here?
• Start with smart trades, then consider your tax implications. No amount of tax-savvy will overcome poor trading!
• When you have an opportunity, take advantage of beneficial tax treatments in the tax code. Trade in your IRA or qualified retirement account instead of your taxable account. If you have multiple accounts (taxable and retirement accounts), consider which accounts you hold various types of securities in. The investments that would generate the most tax liability, in many cases, should be held in your tax-preferred accounts. Choose securities with Section 1256 treatment to benefit from lower overall tax rates on these securities.
• It’s important to keep detailed records and know your cost basis.

Option Trader Q&A w/ Gene

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Gene:

Hey, Kirk. My name is Gene and I really love what you’re doing. Thank you so much for your podcast and your website and the videos and everything. I’ve sent a lot of people to you and we continue doing so and I’ve learned a lot from you. I really appreciate it.

Quick question. I’m trying to become a simpler trader, trying not to over-trade, trying to just mainly trade credit spreads with 30 to 45 days out, similar to what you teach. The question for you is how to – I like to watch the markets every day. I like to see what’s going on. But depending on the market some days, everything on my brokerage account is in the green, in some days it’s red and those emotions flare up when I see too many red numbers, or big red numbers, even though I know I’ve got plenty of time to adjust and plenty of time for the spreads to work out.

Do you have any insight on how to really ignore the market in some ways and not panic whenever I see a spread that I know has plenty of time to work out and everything is in pretty good shape, but still you see red numbers pop up and it just makes you freak out a little bit. Just wondering if you had any insight on how to do that and handle the emotions of waiting for your trade to pan out. Thanks a lot.

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.