It is important to establish a basic understanding of tax law before trading options. In this article, we will study how the United States taxed call options and put options. In other words, we will look at the call and put options exercised, as well as the self-traded options. We will also discuss the tax treatment of wash-sale rules and straddle transactions.
Before proceeding, please note that the author is not a tax professional. This article serves only as an introduction to the tax treatment of options. It is recommended to conduct further due diligence or consult a tax professional.
- If you are trading options, it is likely that you have triggered some taxable events that must be reported to the IRS.
- Although many option profits will be classified as short-term capital gains, the method of calculating the gain (or loss) will vary depending on the strategy and holding period.
- Exercising in-the-money options, closing positions for gains, or engaging in guaranteed teleconferences will all result in different tax treatments.
When a call option is exercised, the premium paid for the option is included in the cost basis of the stock purchase. For example, an investor purchases a call option of ABC Company with a strike price of $20 and an expiration date in June 2020. Investors buy options at a price of $1 or a total of $100, because each contract represents 100 shares. When the stock expires, the trading price is $22, and the investor exercises the option. The cost basis for the entire purchase is $2,100. That is US$20 x 100 shares, plus a premium of US$100, or US$2,100.
Assume that it is August 2020 and the current transaction price of ABC Company is $28 per share. The investor decides to sell his position. A taxable short-term capital gain of $700 was realized. This is the $2,800 benefit minus the $2,100 cost basis, or $700.
For the sake of brevity, we will waive the commission, which can be included in the cost basis. Since the investor exercised the option in June and sold the position in August, the sale was considered a short-term capital gain because the investment was held for less than a year.of
Put options are also subject to similar treatment. If the put option is exercised and the buyer owns the underlying security, the premium and commission of the put option will be added to the cost of the stock. This sum is then subtracted from the selling price of the stock. The elapsed time of the position starts when the stock is first purchased to the time the put option is executed (that is, when the stock is sold).
If the put option is exercised without prior ownership of the underlying stock, tax rules similar to those for short selling apply. The time period starts from the exercise date and ends with closing or closing.of
Pure option play
For the purpose of pure options positions, both long and short options are subject to similar tax treatment. Gains and losses are calculated when the position is closed or is not exercised at maturity. In the case of a bullish or bearish call, all unexercised options that expire are considered short-term gains.Below is an example covering some basic scenarios.
Taylor purchased the October 2020 put option of XYZ Company at a price of US$3 in May 2020 with a strike price of US$50. If they subsequently sell back options when XYZ Company drops to $40 in September 2020, they will be taxed on short-term capital gains (May to September) or $10 minus the premium of the put option and related commissions. In this case, Taylor will tax a short-term capital gain of $700 ($50-$40 strike-$3 premium x 100 shares).
If Taylor writes a US$60 call option for XYZ Company in May, obtains a premium of US$4, expires in October 2020, and decides to repurchase their company in August when XYZ Company’s earnings jump to US$70 due to the blowout. Options, then they are eligible for short-term capital loss 600 USD (70 USD-60 USD strike price + 4 USD premium x 100 shares).
However, if Taylor purchased a $75 strike call option for XYZ in May 2020 at a premium of $4, and it expires in October 2021, and the call option is not exercised before it expires (assuming that XYZ is in The transaction price at expiration is $72), Taylor will realize that the long-term capital loss of their unexercised options is equivalent to a premium of $400. This is because he will own the option for more than a year, making it a long-term tax loss.
Covering a call is slightly more complicated than simply making a long or short call. With guaranteed call options, people who are already long in the underlying securities will sell up call options on that position, which will generate premium income but also limit the upside potential. Taxation of guaranteed calls may fall into one of three situations:
- Call not executed
- Call is executed
- Call option (buy close)
- On January 3, 2019, Taylor owned 100 shares of Microsoft Corporation (MSFT) at a trading price of US$46.90, and wrote a US$50 strike coverage call option, which expires in September 2020 at a premium of US$0.95.
- if Call not executed, Assuming that the transaction price of MSFT at expiration is $48, Taylor will realize a long-term capital gain of $0.95 through their option because the option has been held for more than one year.
- if Call is executed, Taylor will realize capital gains based on their total position time period and their total costs. Assuming they bought the stock for $37 in January 2020, Taylor would realize a short-term capital gain of $13.95 ($50-36.05 or the price they paid minus the call option premium received). This will be short-term because the position was closed a year ago.
- if Phone bought backAccording to the price paid for the purchase callback and the total time of the transaction, Taylor may be eligible for long-term or short-term capital gains/losses.
The above example is strictly applicable to cheap or out-of-price insured phones. The tax treatment of in-the-money (ITM) underwriting calls is much more complicated.
Special consideration: qualified and unqualified treatment
When writing a call option covered by ITM, investors must first determine whether the call option is qualified or Unqualified, Because the latter of the two may have negative tax consequences. If a call option is deemed ineligible, even if the relevant stock has been held for more than a year, it will be taxed at the short-term tax rate. The guidelines for eligibility can be complicated, but the key is to ensure that the call option is not more than one strike price lower than the previous day’s closing price, and that the call option has a period of more than 30 days until expiration.of
For example, Taylor has held MSFT shares at a price of $36 per share since January last year and decided to buy a call option of $45 on June 5, at a premium of $2.65. Since the closing price on the last trading day (May 22) was US$46.90, and the strike price was US$46.50, and the expiration date was less than 30 days, its insured call option was disqualified and its stock holding period will be suspended .If the call option is exercised and Taylor’s stock is redeemed on June 5th, Taylor will achieve short term Capital gains, even if their stocks are held for more than one year.
Protective puts are simpler, albeit just barely. If an investor holds a stock for more than a year and wants to protect his position through a protective put option, the investor will still be eligible for long-term capital gains. If the stock is held for less than a year (for example, 11 months) and the investor purchases a protective put option, even if there is more than one month to expire, the investor’s holding period will immediately expire, and any shares sold The gains will be short-term gains.
If the put option is held before the expiry date of the option and the underlying stock is purchased at the same time, the same is true-no matter how long the put option has been held before the stock is purchased.
Wash sale rules
According to the IRS, the loss of one security cannot be transferred to the purchase of another “essentially the same” security within a 30-day period. The wash sale rules also apply to call options.of
For example, if Taylor loses a stock and purchases a call option on the same stock within 30 days, they will not be able to claim the loss. Instead, Taylor’s loss will be added to the premium of the call option, and the holding period of the call option will begin on the date they sell the stock.
After exercising their call options, the cost basis of their new shares will include call option premiums and stock carry-forward losses. The holding period of these new shares will start from the subscription exercise date.
Similarly, if Taylor takes a loss on an option (call or put) and buys a similar option of the same stock, the loss of the first option will not be allowed, and the loss will be added to the premium of the second option .
Finally, we summarized the tax treatment of straddle transactions. Tax losses on straddle transactions are only recognized when offsetting gains from opposite positions. If an investor enters a straddle position and disposes of a call option with a loss of $500, but has an unrealized gain of $300 on the put option, the investor can only report a loss of $200 in the tax return for the year.of
Option taxes are very complicated, but investors must be very familiar with the rules governing these derivatives. This article is by no means a comprehensive introduction to the nuances of managing option tax treatment, but should only serve as a reminder for further research. For a detailed list of tax nuances, please consult a tax professional.