Special Tax Treatments for Options

In most cases, figuring out your taxes on ordinary stock investments involves a fairly simply process – you either pay taxes on the gains or deduct the losses. How much you pay or deduct depends on whether the stock qualifies as a short- or long-term investment.

Calculating the taxes from trading options is a horse of a different color.  Because trading options involves a more complex transaction, the IRS applies special rules that you need to know about in order to avoid misfiling.

Options Trading Tax Treatment

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Taxes When Selling Options

As with stocks, all profits or losses from trading equity options are considered capital gains or losses (these get reported on IRS Schedule D and Form 8949). However, the rules for determining short- or long-term capital gains/losses depend on whether you’re the option writer or holder.

For example, if the holder sells a put or call option before it expires, the length of time holding the option before selling determines whether it is a short-term or long-term capital gain/loss.

  • 365 days or less = short-term
  • More than 365 days = long-term

When the writer buys back a put or call option before it expires, the IRS considers the capital gain/loss as short-term regardless of how long the writer held the option.

Option Expirations

When a stock option expires, it closes the trade. The writer and holder then 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 holder has the option for 365 days or less before it expires, the gain/loss is short-term. If longer than 365 days, it’s long-term. If the writer buys back the option before it expires, the IRS automatically considers it short-term.

Sounds easy so far. But when an option gets exercised, the tax rules become more complex.

Option Exercises and Stock Assignments

When the writer or holder exercises an option, the IRS applies different tax rules. These rules vary according to whether a put or call gets exercised.

When a put gets exercised, the holder reduces the amount realized from the sale of the underlying stock by the cost of the put. The writer reduces the basis in the stock by the amount received for the put. When a call gets exercised, the holder adds the cost of the call to the basis in the stock purchased, while the writer increases the amount realized on the stock sale by the amount received for the call.

Unlike option sales and expirations, the option position does not get reported on Schedule D Form 8949. Instead, the proceeds are included in the stock position from the assignment. When calculating their taxes, investors should take extra care to properly adjust the costs basis of the stock.

Tax Benefits of Exchange Traded/Broad-Based Index Options

Now it gets even more complex – but better!

The IRS treats the sale of exchange-traded index options or other non-equity securities (bonds, commodities, or currencies), differently than other types of options transactions.

Under IRS Code Section 1256, all gains or losses are subject to the 60/40 rule, which states that 60% of gains/losses are long-term and 40% are short-term – no matter how long the securities are held. This offers several advantages to traders of exchange- and broad-based index options.

The primary benefit comes from paying lower capital gains taxes. The maximum tax rate for long-term capital gains tops out at 23.8%, while short-term rates can go as high as 43.4%. Additionally, excess losses may be carried forward indefinitely, and you can carry a loss up to three years back to offset any Sec. 1256 gains.

The 60/40 rule also applies to certain financial contracts when held for less year.  These include regulated futures and foreign currency contracts as well as non-equity, debt, commodity futures and currency options. The IRS considers these contracts as “marked to market” at the end of the year, and treats them as if they were closed. Holding them longer will incur higher capital gains taxes.

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.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.