It is crucial to build a basic understanding of tax laws prior to trading options. In this article, we will examine how calls and puts are taxed in the United States. Namely, we will look at calls and puts that are exercised, as well as options that are traded on their own. We will also discuss the wash sale rule and the tax treatment of straddles.
Before going any further, please note the author is not a tax professional. This article should serve only as an introduction to the tax treatment of options. Further due diligence or consultation with a tax professional is recommended.
- If you're trading options, chances are you've triggered some taxable events that must be reported to the IRS.
- While many options profits will be classified as short-term capital gains, the method for calculating the gain (or loss) will vary by strategy and holding period.
- Exercising in-the-money options, closing out a position for a gain, or engaging in covered call writing will all lead to somewhat different tax treatments.
When call options are exercised, the premium paid for the option is included in the cost basis of the stock purchase. Take for example an investor who buys a call option for Company ABC with a $20 strike price and June 2020 expiry. The investor buys the option for $1, or $100 total as each contract represents 100 shares. The stock trades at $22 upon expiry and the investor exercises the option. The cost basis for the entire purchase is $2,100. That's $20 x 100 shares, plus the $100 premium, or $2,100.
Let's say it is August 2020 and Company ABC now trades at $28 per share. The investor decides to sell their position. A taxable short-term capital gain of $700 is realized. That's $2,800 in proceeds minus the $2,100 cost basis, or $700.
For the sake of brevity, we will forgo commissions, which can be included in the cost basis. Because the investor exercised the option in June and sold the position in August, the sale is considered a short-term capital gain, as the investment was held for less than a year.
Put options receive a similar treatment. If a put is exercised and the buyer owned the underlying securities, the put's premium and commissions are added to the cost basis of the shares. This sum is then subtracted from the shares' selling price. The position's elapsed time begins from when the shares were originally purchased to when the put was exercised (i.e., when the shares were sold).
If a put is exercised without prior ownership of the underlying stock, similar tax rules to a short sale apply. The time period starts from the exercise date and ends with the closing or covering of the position.
Pure Options Plays
Both long and short options for the purposes of pure options positions receive similar tax treatments. Gains and losses are calculated when the positions are closed or when they expire unexercised. In the case of call or put writes, all options that expire unexercised are considered short-term gains. Below is an example that covers some basic scenarios.
Taylor purchases an October 2020 put option on Company XYZ with a $50 strike in May 2020 for $3. If they subsequently sell back the option when Company XYZ drops to $40 in September 2020, they would be taxed on short-term capital gains (May to September) or $10 minus the put's premium and associated commissions. In this case, Taylor would be taxed on a $700 short-term capital gain ($50 - $40 strike - $3 premium paid x 100 shares).
If Taylor writes a call $60 strike call for Company XYZ in May, receiving a premium of $4, with an October 2020 expiry, and decides to buy back their option in August when Company XYZ jumps to $70 on blowout earnings, then they are eligible for a short-term capital loss of $600 ($70 - $60 strike + $4 premium received x 100 shares).
If, however, Taylor purchased a $75 strike call for Company XYZ for a $4 premium in May 2020 with an October 2021 expiry, and the call is held until it expires unexercised (say Company XYZ will trade at $72 at expiry), Taylor will realize a long-term capital loss on their unexercised option equal to the premium of $400. This is because he would have owned the option for more than one year's time, making it a long-term loss for tax purposes.
Covered calls are slightly more complex than simply going long or short a call. With a covered call, somebody who is already long the underlying security will sell upside calls against that position, generating premium income but also limiting upside potential. Taxing a covered call can fall under one of three scenarios for at or out-of-the-money calls:
- Call is unexercised
- Call is exercised
- Call is bought back (bought-to-close)
- On January 3, 2019, Taylor owns 100 shares of Microsoft Corporation (MSFT), trading at $46.90, and writes a $50 strike covered call, with September 2020 expiry, receiving a premium of $0.95.
- If the call goes unexercised, say MSFT trades at $48 at expiration, Taylor will realize a long-term capital gain of $0.95 on their option, since the option was held for more than one year.
- If the call is exercised, Taylor will realize a capital gain based on their total position time period and their total cost. Say they bought shares in January of 2020 for $37, Taylor will realize a short-term capital gain of $13.95 ($50 - $36.05 or the price they paid minus call premium received). It would be short-term because the position was closed prior to one year.
- If the call is bought back, depending on the price paid to buy the call back and the time period elapsed in total for the trade, Taylor may be eligible for long- or short-term capital gains/losses.
The above example pertains strictly to at-the-money or out-of-the-money covered calls. Tax treatments for in-the-money (ITM) covered calls are vastly more intricate.
Special Considerations: Qualified vs. Unqualified Treatment
When writing ITM covered calls, the investor must first determine if the call is qualified or unqualified, as the latter of the two can have negative tax consequences. If a call is deemed to be unqualified, it will be taxed at the short-term rate, even if the underlying shares have been held for over a year. The guidelines regarding qualifications can be intricate, but the key is to ensure that the call is not lower by more than one strike price below the prior day's closing price, and the call has a time period of longer than 30 days until expiry.
For example, Taylor has held shares of MSFT since January of last year at $36 per share and decides to write the June 5 $45 call receiving a premium of $2.65. Because the closing price of the last trading day (May 22) was $46.90, one strike below would be $46.50, and since the expiry is less than 30 days away, their covered call is unqualified and the holding period of their shares will be suspended. If on June 5, the call is exercised and Taylor's shares are called away, Taylor will realize short-term capital gains, even though the holding period of their shares was over a year.
Protective puts are a little more straightforward, though barely just. If an investor has held shares of a stock for more than a year and wants to protect their position with a protective put, the investor will still be qualified for long-term capital gains. If the shares have been held for less than a year (say eleven months) and the investor purchases a protective put, even with more than a month of expiry left, the investor's holding period will immediately be negated and any gains upon sale of the stock will be short-term gains.
The same is true if shares of the underlying are purchased while holding the put option before the option's expiration date—regardless of how long the put has been held prior to the share purchase.
Wash Sale Rule
According to the IRS, losses of one security cannot be carried over towards the purchase of another "substantially identical" security within a 30-day time-span. The wash sale rule applies to call options as well.
For example, if Taylor takes a loss on a stock, and buys the call option of that very same stock within thirty 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 will start from the date that they sold the shares.
Upon exercising their call, the cost basis of their new shares will include the call premium, as well as the carryover loss from the shares. The holding period of these new shares will begin upon the call exercise date.
Similarly, if Taylor were to take a loss on an option (call or put) and buy a similar option of the same stock, the loss from the first option would be disallowed, and the loss would be added to the premium of the second option.
Finally, we conclude with the tax treatment of straddles. Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. If an investor were to enter a straddle position, and disposes of the call at a $500 loss but has unrealized gains of $300 on the puts, the investor will only be able to claim a $200 loss on the tax return for the current year.
The Bottom Line
Taxes on options are incredibly complex, but it is imperative that investors build a strong familiarity with the rules governing these derivative instruments. This article is by no means a thorough presentation of the nuances governing option tax treatments and should only serve as a prompt for further research. For an exhaustive list of tax nuances, please seek a tax professional.