Investment Taxes

Tax laws, rulings, and regulations change often, and each investor’s tax situation is unique based on their income from other sources, deductions, credits, and other criteria.

Tax Terms

Earned Income (Ordinary Income)

Includes wages, salaries, tips, and net earnings from self-employment. Earned income 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. 

Income Taxes

Taxes on income, both earned (salaries, wages, tips, commissions) and unearned (interest, dividends). Income taxes can be levied on individuals (personal income taxes) and businesses (business and corporate income taxes).

The amount of income tax owed varies by income source (ordinary income, interest income, dividends, capital gains, etc.).

Short-term

Describes a holding period of one year or less.

For example, Bob bought IBM stock on April 1 and sold the same stock for a gain on May 15. Bob’s holding period for IBM is classified as short-term.

Long-term

Describes a holding period of more than one year.

For example, Sue bought AAPL stock on April 1 and sold the same stock for a gain on June 1 of the following year. Since Sue held AAPL for more than one year, her gain is considered long-term.

Capital Gain

A capital gain is an increase in an asset’s value that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold.

For example, Sally purchased NFLX stock at $300 per share and sold her shares for $350. Sally’s sale of NFLX is subject to capital gains taxes.

For options, a capital gain may be a profit between the purchase and sale of an asset (regardless of whether the purchase or sale came first).

For example, Bill sold a call option on GLD for $3.00 in premium and bought back the call at $1.50 a month later for a profit.

A capital gain may be short-term or long-term and must be claimed on your income taxes.

Capital Loss

A capital loss is a loss that occurs when an asset is sold for less than its purchase price. This loss is not realized until the asset is sold for a lower price than the original purchase price.

For options, a capital loss may be a loss between an asset’s purchase and sale (regardless of whether the purchase or sale came first).

For example, Shelly sold a call option on TLT for $4.00 in premium and then bought back the call option for $5.00 a month later. Shelly had a capital loss of $1.00 on the transaction as the purchase price ($5) exceeded the price on the original sale ($4).

Capital losses are subtracted from any capital gains and may be used to reduce the taxable income reported. There are limits to the amount of capital loss that can be deducted each tax year. If the capital loss exceeds the limit, the difference may be carried over to the following tax year or years.

Brokers submit form 1099-B to the IRS and provide a copy to account holders who sold stock, options, commodities, and other securities and had capital gains or losses during the tax year. Form 1099-B shows the investment, purchase date and price, sales date and price, and the resulting profit or loss. 

Wash Sale

A stock wash sale occurs when a security is sold or traded at a loss and, within 30 days of the sale, a substantially identical security is 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 security. Wash sale rules apply across accounts, including accounts held at different brokerage firms. 

For example, Brad has a taxable investment account that holds 10 shares of CAT. His cost basis is $1,000 because he bought his shares at $100. On August 31, the shares are worth $900 (10 shares at $90 per share), and he sells his shares at a loss. On September 15, he repurchased 10 shares of CAT at $105 per share.

Because his purchase on September 15 was within 30 days of his sale at a loss, the loss from August 31 is disallowed (or deferred), and his cost basis on the September 15 purchase is adjusted higher by the amount of the September 15 loss.

Account types

Standard or individual brokerage accounts have one owner and are not tax-advantaged. Account owners are responsible for reporting gains, losses, interest income, and dividends for each tax year.

There are no required distributions in standard, individual brokerage accounts, and deposits and withdrawals from this account type are at the discretion of the account owner. Typically, this account type is selected for investors with excess funds beyond retirement account contributions or those who desire access to the funds invested before retirement. 

Individual Retirement Arrangements (IRAs), Roth IRAs, 401(k) Plans, 403(b) Plans, SIMPLE IRA Plans, SEP Plans, and other retirement plans were created to encourage saving for retirement.

By deferring taxation on income or allowing earnings to grow tax-free, qualified retirement plans provide a distinct advantage when it comes to saving money on taxes.

Taxes on stocks

Stock ownership is subject to capital gains or losses on the sale of positions and taxation on dividend distributions received. Taxes are paid on the capital gains or the capital loss is a deduction from income. The amount of taxes paid or deducted depends on whether the stock qualifies as a short- or long-term investment.

Cost Basis

The gain or loss on the sale of a stock is calculated by subtracting the stock’s cost basis from the amount realized on the sale or trade.

The cost basis of a stock is typically the amount paid for the security. The cost basis may be the price paid for a one-time purchase of stock or the average purchase price for shares accumulated over a period of time. The basis of stock must be adjusted for certain events that occur after purchase, such as stock splits or dividends.

If the amount realized from a sale is more than the cost basis in the position, the difference is a gain. If the cost basis in the position is more than the amount realized in the sale of the position, the difference is a loss.

The holding period for stock received as a taxable stock dividend begins on the date of distribution.

Form 8949 is used to total gains and losses from the Form 1099-B received from a broker. The subtotals from Form 8949 are carried over to Schedule D where gain or loss totals for the year are aggregated. Schedule D of Form 1040 is used to report the overall gain or loss from transactions reported on Form 8949.

Wash Sales

Wash sales can impact the cost basis on positions and are an important part of income taxation of investments.

A wash sale occurs when a stock or security is sold or traded at a loss and within 30 days before or after the sale and the account holder 1) buys substantially identical stock or securities, 2) acquires substantially identical stock or securities in a fully taxable trade, 3) acquires a contract or option to buy substantially identical stock or securities, or 4) acquires substantially identical stock or securities in an IRA or Roth IRA.

If an account owner sells stock and their spouse buys a substantially identical stock, a wash sale occurs. 

For example, on June 1, Bob sells XYZ stock at $200 for a $50 loss. On June 15, Bob repurchases XYZ at $205. Because the repurchase was within 30 days of the June 1 loss, the June 15 purchase cost is adjusted higher (from $205 to $255) because of the wash sale loss. 

If a loss was disallowed because of the wash sale rules, the disallowed loss would be added to the new stock or securities’ cost basis. The wash sale adjustment essentially postpones or delays the loss deduction until the new stock or security is sold. The holding period for the new stock acquired in a wash sale includes the period the old stock was held.

Without the wash sale rule, an investor may sell a security at a loss just to receive a tax deduction and lower income tax liability, and then re-enter the position right away. The wash sale rule was designed to discourage the selling of securities at a loss simply to claim a tax benefit.

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 a 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.

Distributions

Most distributions from stock positions are paid in cash to shareholders. However, distributions can also consist of stock. When a security held pays a dividend, the account owner will receive Form 1099-DIV to show the distribution received during the year. 

Ordinary dividends are the most common type of distribution from a corporation or mutual fund and are paid out of earnings. Profits are treated as ordinary income--not capital gains. Dividends received may be assumed to be ordinary dividends unless the paying corporation or fund specifies otherwise.

Qualified dividends are taxed at the capital gains rate (lower than ordinary income). Qualified dividends are reported in a separate box on Form 1099-DIV (box 1b).

For a dividend to be qualified, it must have been issued by a U.S. corporation or a foreign corporation that trades on a major U.S. exchange, and the account owner must have owned the underlying shares for more than 60 days during the 121-day period that begins 60 before the ex-dividend date.

For example, Sue purchased 100 shares of XYZ on July 11. XYZ declares a 5 cent per share dividend, and the ex-dividend date is July 12. Sue sold shares of XYZ on September 13, which is a holding period of 63 days. The dividend is qualified because she held the stock for 61 days of the 121-day period from July 12 through September 13.

The payer of the dividend is required to correctly identify each type and amount of dividend when reporting them on Form 1099-DIV for tax purposes.

Taxes on options

The IRS applies special rules for calculating taxes on options trades depending on if the account owner was the buyer or the seller, the type of contract used, and the strategy deployed.

Taxes When Selling 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 Bob purchased a call option for $3 to buy XYZ, and XYZ subsequently rallies, the call option’s value increases to $5, and Bob sells the call option for $5, Bob has 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.

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

If Bob had purchased the call option on XYZ for $3 on June 1 and then sold the option on September 1 for $5, he would have a short-term capital gain because the position was held less than one year.

The rules for determining short- or long-term capital gains/losses depend on whether the account owner is the option buyer or seller.

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 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. When selling short options (sell-to-open), when the position is closed (buy-to-close), either through buying back the option or at expiration, the result will be a short-term gain or loss for tax purposes. 

The calculations of capital gains or losses when buying options and selling options are straightforward when the position is closed early or the position expires worthless. There are no cost basis adjustments for these pure option plays.

Option Expirations

Intrinsic value is how much an option contract is in the money and extrinsic value is how much more the market price of an option is above its intrinsic value. At expiration, extrinsic value is $0 and only intrinsic value remains.

If a call option has a strike price of $50 and the underlying stock is trading at $55, then the call option has $5 of intrinsic value. An option seller is most profitable when the options sold expire worthless.

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 short-term capital gain or loss. For an option seller, the gain or loss is a short-term capital gain or loss. 

If the option expires worthless, the trade is closed at $0. For holding period purposes, if the option holder has a loss because the option was not exercised and it expires worthless, the holder is considered to have sold or traded the option on the date it expired (the expiration date is the date reported to the IRS as the closing date of the trade).

If the buyer holds the option for 365 days or less before it expires, the gain or loss is short-term. If the option is held longer than 365 days, it is a long-term capital gain or loss for the buyer. If the seller buys back the option before it expires or the contract expires without expiration, the IRS considers it a short-term capital gain or loss.

Bottom line: if an option is sold and the option is not exercised, the premium received is a short-term capital gain.

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.

Option Exercises and Stock Assignments

When an option 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 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 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 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 option’s sale 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 cost basis of the stock position.

Option Adjustments

The IRS definition of the word “straddle” is different from the meaning typically used in the options community regarding multi-legged positions. In options 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. 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, Bob enters 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, he closes 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 he sold for $8). 

The account owner cannot deduct a loss on the sale of a straddle if, within a period of 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.

Tax Benefits of Broad-Based Index Options - Section 1256 Contracts

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 U.S.’s highest tax rate 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.

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.