It is absolutely crucial to build at least a basic understanding of tax laws prior to embarking upon any options trades. In this article, we will look at how calls and puts are taxed in the US, namely, calls and puts for the purpose of exercise, as well as calls and puts traded on their own. We will also look at the “Wash Sale Rule” and the tax treatment of option straddles. But before we go any further, please note that the author is not a tax professional and this article should only serve as an introduction to the tax treatment of options. Further due diligence or consultation with a tax professional is highly recommended.
Firstly, when call options are exercised, the premium is included as part of the cost basis of a stock. For example, if Mary buys a call option for Stock ABC in February with a $20 strike price and June 2015 expiry for $1, and the stock trades at $22 upon expiry, Mary exercises her option. Her cost basis for the 100 shares of ABC is $2100 ($20 per share x 100, plus $100 premium). If Mary decides to sell her position of 100 shares in August when ABC is now trading at $28, she will realize a taxable short-term capital gain of $700: $28 to sell the shares that cost her $21 to receive. For brevity sake, we will forgo commissions, which can be tacked onto the cost basis of her shares. The tax time period is considered short-term as it is under a year, and the range is from the time of option exercise (June) to time of selling her stock (August).
Put options receive a similar treatment: if a put is exercised and the buyer owned the securities, the put's premiums and commissions are added to the cost basis of the shares/ subtracted from the selling price upon exercise. The position's elapsed time begins from when the shares were originally purchased to when the put was exercised (shares were sold). If a put is exercised without prior ownership of the underlying stock, similar tax rules to a short sale are applied, with the total time period ranging from exercise date to closing/ covering 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 /put writes, all options that expire unexercised are considered short-term gains. Below is an example that covers some basic scenarios:
Bob purchases an October 2015 put option on XYZ with a $50 strike in May 2015 for $3. If he subsequently sells back the option when XYZ drops to $40 in September 2015, he would be taxed on short-term capital gains (May to September) or $10 minus the put’s premium and associated commissions. In this case, Bob would be eligible to be taxed on a $7 short-term capital gain.
If Bob writes a call $60 strike call for ABC in May, receiving a premium of $4, with an October 2015 expiry, and decides to buy back his option in August when XYZ jumps to $70 on blowout earnings, then he is eligible for a short term capital loss of $600 ($70 – $60 strike + $4 premium received).
If, however, Bob purchased a $75 strike call for ABC for a $4 premium in May 2015 with an October 2016 expiry, and the call expires unexercised (say XYZ will trade at $72 at expiry), Bob will realize a long-term capital loss on his unexercised option equal to the premium of $400.
Covered Calls and Protective Puts
Covered calls are slightly more complex than simply going long or short a call, and can fall under one of three scenarios for at or out-of-the-money calls: (A) call is unexercised, (B) call is exercised, or (C) call is bought back (bought-to-close).
We will revisit Mary for this example.
Mary owns 100 shares of Microsoft Corporation (MSFT), currently trading at $46.90, and she writes a $50 strike covered call, September expiry, receiving a premium of $.95.
- If the call goes unexercised, say MSFT trades at $48 at expiration, Mary will realize a short-term capital gain of $.95 on her option.
- If the call is exercised, Mary will realize a capital gain based on her total position time period and her total cost. Say she bought her shares in January of 2014 for $37, Mary will realize a long-term capital gain of $13.95 ($50 - $36.05 or the price she paid minus call premium received).
- 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, Mary 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.
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, Mary 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, her covered call is unqualified and the holding period of her shares will be suspended. If on June 5, the call is exercised and Mary’s shares are called away, Mary will realize short-term capital gains, even though the holding period of her shares were over a year.
For a list of guidelines governing covered call qualifications, please see the official IRS documentation here, as well as, a list of specifications regarding qualified covered calls can also be found at Investor's Guide.
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, he or she will still be qualified for long-term capital gains. If the shares had been held for less than a year, say eleven months, and if 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 Beth takes a loss on a stock, and buys the call option of that very same stock within thirty days, she will not be able to claim the loss. Instead, Beth’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 she sold the shares. Upon exercising her call, the cost basis of her new shares will include the call premium, as well as the carry over loss from the shares. The holding period of these new shares will begin upon the call exercise date.
Similarly, if Beth 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 Chris were to enter a straddle position, and disposes of the call at a $500 loss, but has unrealized gains of $300 on the puts, Chris will only be able to claim a $200 loss on the tax return for the current year. (See Related Article: How The Straddle Rule Creates Tax Opportunities For Options Traders.)
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 nuisances governing option tax treatments and should only serve as a prompt for further research. For an exhaustive list of tax nuisances, please seek a tax professional.