Although the world of futures and options trading offers exciting possibilities for making huge profits, potential futures or options traders must at least be familiar with the basics of the tax rules surrounding these derivatives. This article will briefly introduce complex options tax rules and less complex futures guidelines.
However, the tax treatment of these two tools is very complicated, and readers are encouraged to consult a tax professional before starting a transaction.
Tax treatment of futures
According to Article 1256 of the Internal Revenue Code (IRC), futures traders can enjoy more preferential tax treatment than stock traders. 1256 stipulates that any futures contracts, foreign currency contracts, dealer stock options, dealer securities futures contracts, or non-stock options contracts traded on U.S. exchanges are taxed at a rate of 60% of the long-term capital gains rate and the short-term capital gains rate of 40%– No matter how long the transaction is open. Since the long-term capital gain rate is up to 20%, the short-term capital gain rate is up to 37%, and the total tax rate is up to 26.8%.
Article 1256 contracts are also marked on the market at the end of each year; traders can report all realized and unrealized gains and losses, and are not subject to wash-out rules.
For example, in February of this year, Bob bought a contract worth $20,000. If on December 31 (the last day of the tax year), the fair market value of the contract is US$26,000, Bob will recognize a capital gain of US$6,000 in his 2019 tax return. This $6,000 will be taxed at the 60/40 rate.
Now, if Bob sells his contract for $24,000 in 2020, he will be recognized as a loss of $2,000 in the 2016 tax return, which will also be taxed at 60/40.
If a futures trader wishes to carry forward any losses in accordance with the provisions of Article 1256, they can carry forward up to three years, provided that the losses carried forward do not exceed the net income of the previous year and cannot increase the operating losses of the current year. Losses are carried forward to the earliest year first, and any remaining amounts are carried forward to the next two years. As usual, the 60/40 rule applies. Conversely, if there are still any unabsorbed losses after the carryover, These losses can be carried forward.
Tax treatment of options
The tax treatment of options is much more complicated than that of futures. Both authors and buyers of call options and put options may face long-term or short-term capital gains and are subject to wash-out and straddle rules.
If the transaction lasts less than a year, option traders who buy and sell options with gains or losses may be taxed on a short-term basis, and if the transaction lasts more than a year, they may be taxed on a long-term basis. If the previously purchased option expires and is not exercised, the buyer of the option will face a short-term or long-term capital loss, depending on the total holding period.
The sellers of options will recognize gains on a short-term or long-term basis based on the situation when they close their positions. If the options they wrote are implemented, the following situations may occur:
- If the written option is a naked call option, the stock will be called back and the premium received will be added to the selling price of the stock. Since this is a stark choice, the transaction will be taxed in the short term.
- If the option written is a guaranteed call option, and the strike price is out of the money or at par, then the premium of the call option will be added to the selling price of the stock, and the transaction will be taxed as a short-term or long-term capital gain, depending on The time that the author of the secured call option owns the stock before the option is exercised.
- If a guaranteed call option is written for an in-the-money strike, then depending on whether the call option is a qualified or unqualified guaranteed call option, the writer may have to require short-term or long-term capital gains.
- If the option sold is a put option and the option is exercised, then the seller only needs to subtract the premium received by the put option from their average stock cost. Similarly, depending on the length of time the transaction remains open from the time the option is exercised/acquired to the time the stock is sold, long-term or short-term taxation can be imposed on the transaction.
For the seller of put and call options, if the option expires and is not exercised or is bought and closed, it will be regarded as a short-term capital gain.
On the contrary, when the buyer exercises the option, the process is slightly less complicated, but they still have subtle differences. When a call option is exercised, the premium paid for the option will be added to the buyer’s current long stock cost basis. The transaction will be taxed on a short-term or long-term basis, depending on how long the buyer holds the stock before selling it back.
On the other hand, buyers of put options must ensure that they hold stocks for at least one year before purchasing protective put options, otherwise they will be taxed on short-term capital gains. In other words, even if Sandy holds her stock for 11 months, if Sandy purchases a put option, her entire holding period will be cancelled and she must now pay short-term capital gains.
Below is a picture from Internal Revenue Service, Summarize the tax rules for option buyers and sellers:
Wash sale rules
Although futures traders do not have to worry about the wash sale rules, option traders are not so lucky. According to the wash sale rules, the losses of “basically” the same securities cannot be carried forward within a 30-day time span. In other words, if Mike loses on certain stocks, he cannot convert this loss to a call option on the same stock within 30 days of the loss. Instead, Mike’s holding period will begin on the day he sells the stock. When the call option is exercised, the call option premium and the initial sale loss will be added to the cost basis of the stock.
Similarly, if Mike takes a loss on one option and buys another option on the same underlying stock, the loss will be added to the premium of the new option.
For tax purposes, straddle options include a broader concept than ordinary option straddles, which involve call options and put options with the same strike price. The IRS defines straddle options as taking opposite positions in similar instruments to reduce the risk of loss, because these instruments are expected to be inversely proportional to market trends. Essentially, if straddle is regarded as the “basic” for tax purposes, the losses incurred by one part of the transaction are only reported in the tax for the year, and these losses offset the unrealized gains of the opposite position.
In other words, if Alice enters a straddle position in XYZ in 2020, and then the stock price plummets, she decides to sell her call options back at a loss of $8, while retaining her put options (now has an unrealized gain of $5) According to the straddle rule, she can only confirm a loss of $3 in the 2020 tax return instead of the total loss of $8 for the call option. If Alice chooses to “identify” this straddle option, the entire $9 loss of the call option will be included in the cost of her put option. The IRS has a list of rules for straddle identification.
For more information on straddle rules, see How straddle rules create tax opportunities for option traders.
Although the tax declaration process for futures may seem simple, the tax treatment of options is not. If you are considering trading or investing in any of these derivatives, then you must at least be familiar with the various tax rules waiting for you. Many tax procedures, especially those related to options, are beyond the scope of this article. This article serves only as a starting point for further due diligence or consultation with tax professionals.