While the world of futures and options trading offers exciting possibilities to make substantial profits, the prospective futures or options trader must familiarize herself with at least a basic knowledge of the tax rules surrounding these derivatives. This article will be a brief introduction to the complex world of options tax rules and the not-so-complex guidelines for futures. However, tax treatments for both these types of instruments are incredibly complex, and the reader is encouraged to consult with a tax professional before embarking upon their trading journey.
Tax treatment of Futures
Futures traders benefit from a more favorable tax treatment than equity traders under Section 1256 of the Internal Revenue Code (IRC). 1256 states that any futures contract traded on a US exchange, foreign currency contract, dealer equities option, dealer securities futures contract, or index futures contract are taxed long-term capital gains rates of 60 percent and short-term capital gains rates of 40 percent—regardless of how long the trade was opened for. As the maximum long-term capital gains rate is 15 percent and the maximum short-term capital gains rate is 35 percent, the maximum total tax rate stands at 23 percent.
Section 1256 contracts are also marked to market at the end of each year; traders can report all realized and unrealized gains and losses, and are exempt from wash-sale rules.
For example, in February of this year, Bob bought a contract worth $20,000. If on December 31 (last day of the tax year) the fair market value of this contract is $26,000, Bob will recognize a $6000 capital gain on his 2015 tax return. This $6000 will be taxed on the 60/40 rate.
Now if Bob sells his contract in 2016 for $24,000, he will recognize a $2000 loss on his 2016 tax return, which will also be taxed on the 60/40 basis.
Should a futures trader wish to carry back any losses under Section 1256, they are allowed to do so for up to three years, under the condition that the losses being carried back do not exceed the net gains of that previous year, nor can it increase an operating loss from that year. The loss is carried back to the earliest year first, and any remaining amounts are carried to the next two years. As usual, the 60/40 rule applies. Conversely, if any unabsorbed losses still remain after the carry-back, these losses can be carried forward.
Tax Treatment of Options
Tax treatment of options is vastly more complex than futures. Both writers and buyers of calls and puts can face both long- or short-term capital gains, as well as be subject to wash-sale and straddle rules.
Options traders who buy and sell back their options at gains or losses may be taxed on a short-term basis if the trade lasted less than a year, or a long-term basis if the trade lasted longer than a year. If a previously bought option expires unexercised, the buyer of the option will face a short- or long-term capital loss, depending on the total holding period.
Writers of options will recognize gains on a short- or long-term basis depending on the circumstances when they close out their positions. If the option they have written gets exercised, several things can happen:
- If the written option was a naked call, the shares would be called away and the premium received will be tacked onto the selling price of the shares. Since this was a naked option, the transaction would be taxed on a short-term basis.
- If the written option was a covered call and if the strikes were out of or at the money, then the call premium would be added to the selling price of the shares and the transaction would be taxed either as a short- or long-term capital gain, depending on how long the writer of the covered call owned the shares prior to option exercise.
- If the covered call was written for an in-the-money strike, then depending on whether or not the call was a qualified or unqualified covered call, the writer may have to claim short- or long-term capital gains. Here is a list of qualified covered call specifics.
- If the written option was a put and the option gets exercised, the writer would simply subtract the premium received for the put from their average share cost. Again, depending on how long the trade is held open for from the time of option exercise/ shares were acquired to when the writer sells back the shares, the trade could be taxed on a long- or short-term basis.
For both put and call writers, if an option expires unexercised or is bought to close, it is treated as a short-term capital gain.
Conversely, when a buyer exercises an option, the processes are slightly less complicated, but they still have their nuances. When a call is exercised, the premium paid for the option is tacked onto the cost basis of the shares the buyer is now long in. The trade will be taxed on a short- or long-term basis, depending on how long the buyer holds the shares before selling them back.
A put buyer, on the other hand, has to ensure that they have held the shares for at least a year before purchasing a protective put, otherwise they will be taxed on short-term capital gains. In other words, even if Sandy has held her shares for eleven months, if Sandy purchases a put option, the entire holding period of her shares get negated, and she now has to pay short-term capital gains.
While futures traders do not have to worry about the wash-sale rules, option traders are not as fortunate. Under the wash-sale rule, losses on "substantially'' identical securities cannot be carried forward within a 30-day time span. In other words, if Mike takes a loss on some shares, he cannot carry this loss towards a call option of the very same stock within 30 days of the loss. Instead, Mike's holding period will begin on the day he sold the shares, and the call premium, as well as the loss from the original sale, will be added to the cost basis of the shares upon exercise of the call option.
Similarly, if Mike were to take a loss on an option and buy another option of the same underlying stock, the loss would be added to the premium of the new option.
Straddles for tax purposes encompass a broader concept than the plain vanilla options straddle. The IRS defines straddles as taking opposite positions in similar instruments to diminish the risk of loss, as the instruments are expected to vary inversely to market movements. Essentially, if a straddle is considered "basic" for tax purposes, the losses accrued to one leg of the trade are only reported on the current year's taxes to the extend that these losses offset an unrealized gain on the opposite position. In other words, if Alice enters a straddle position on XYZ in 2015 and the stock subsequently plummets, and she decides to sell back her call option for an $8 loss, while keeping her put option (which now has an unrealized gain of $5), under the straddle rule, she can only recognize a loss of $3 on her 2015 tax return—not the $8 in its entirety from the call option. If Alice had elected to "identify" this straddle, the entire $9 loss on the call will be tacked onto the cost basis of her put option.
The IRS has a list of rules pertaining to the identification of a straddle.
Further information on the straddle rule can be found in How the Straddle Rule Creates Tax Opportunities for Options Traders.
The Bottom Line
While the tax reporting process of futures is seemingly straightforward, the same cannot be said regarding the tax treatment of options. If you are thinking of trading or investing in either of these derivatives, it is imperative that you build at least a passing familiarity with the various tax rules that await you. Many tax procedures, especially those that pertain to options, are beyond the scope of this article, and this reading should serve only as a starting point for further due diligence or consultation with a tax professional.