Want to trade options? Be sure you understand the tax implications first.
Before getting into the details, though, it's important to note that the following discussion applies to "investors"—i.e. most nonprofessional retail traders. IRS terminology doesn't always match the language used within the financial industry. For example, some people who consider themselves to be "traders" (aka day traders or active traders) are most likely considered "investors" in the eyes of the IRS.
To be considered a trader by the IRS you must be in the "business of trading," which basically means trading is your day job. Those in the "business of trading" should meet with a tax professional and consider reading IRS publication 550 and IRS Topic No. 429 Traders in Securities.)
Here are some basic things to consider when it comes to buying and selling these contracts on the open market.
Taxes for investors
For tax purposes, options can be classified into three main categories:
1. Employee stock options
These are generally options contracts given to employees as a form of compensation and aren't traded on the open market. There are two primary types: non-qualified stock options and incentive stock options.
Generally, the gains from exercising non-qualified stock options are treated as ordinary income, whereas gains from an incentive stock option can either be treated as ordinary income or taxed at a preferential rate if certain requirements are met. To learn more about employee stock options, see How Should Equity Compensation Fit Into Your Financial Plan.
2. Equity options
These are options contracts on equities that can be traded on the open market. Examples include puts or calls on individual stocks or ETFs that hold stocks.
How they're taxed depends on whether you have a long position (where you're the buyer of the option) or a short position (where you're the seller/writer of the option). The table below provides an overview, but be aware that if you're doing more complex options transactions, such as spreads or butterflies, the IRS may apply different tax rules (see below for more details).
| Long Options (buy) | If you close the position before expiration | If you exercise the option | If the option expires |
|---|---|---|---|
| Long Call | The holding period of the option determines if it's taxed at short- or long-term capital tax rates. | • Exercising a call option increases the cost basis of the stock that is purchased. • There is no taxable event until the stock is finally sold. • Once sold, the holding period of the stock determines if the capital gain or loss is short- or long-term. | The holding period of the option determines if the capital loss is short- or long-term. |
| Long Put | Same as above. | • Exercising a put option reduces the amount realized from the sale of the underlying stock by the cost of the put. | Same as above. |
| Short Options (sell/write) | If position is closed before the expiration | If the option is exercised (assigned to you) | If the option expires |
|---|---|---|---|
| Short Call | Regardless of holding period, the capital gain or loss is always considered short-term. | • The capital gain or loss is treated as short- or long-term depending on your holding period for the stock. • The amount you received for writing the option is added to the amount received from the sale of the stock. | Report the amount received for writing the option as a short-term capital gain. |
| Short Put | Same as above. | •Your holding period for the stock begins on the date you buy it. • If the put option is exercised and you buy the underlying stock, decrease the stock's cost basis by the amount received for writing the option. | Same as above. |
What about complex equity options strategies?
You can use options to pursue a variety strategies, among them writing covered calls and using spreads, straddles, strangles, or butterflies, etc. However, note that the IRS groups most of these complex options strategies together and refers to them as a "straddle."
For tax purposes, a straddle occurs when you open an options position that offsets or substantially reduces the risk of loss for another position you're also holding. For example, if you held some $80 stock and bought a put option with a $70 strike price to protect against a price drop, you have created a straddle in the eyes of the IRS. In such cases, different tax rules apply:
- Losses on straddles are generally deferred: Any losses are included in the basis of the remaining position and eventually recognized when the final position is closed. So, if only one side of a straddle position is closed, realized losses generally aren't deductible until the offsetting position is also closed out. Note: Any loss that exceeds the unrecognized gain from an offsetting position can generally be deducted.
- Qualified covered calls (QCCs) are not subject to the straddle rules: The IRS groups covered calls into two categories, qualified or unqualified, and each is taxed differently. Generally, QCCs are options written with an expiration date greater than 30 days and a strike price that is not "deep-in-the-money" (see IRS Publication 550 to learn more). If the covered call doesn't meet these requirements, then it's considered "unqualified" and is taxed as a straddle.
- Offsetting section 1256 options are exempt from this rule: Straddles consisting entirely of Section 1256 options are not taxed as straddles (see more below).
The idea behind the straddle taxation rules is to prevent investors from deducting losses before an offsetting gain is recognized.
The wash sale rules generally apply to options
The same wash sale rules that apply to stock, also apply to stock option trades. If a substantially identical security is acquired within 30 days before or after the sale occurs, the loss is disallowed and the basis is transferred to the new position.
3. Non-equity options taxation
This refers to options that be traded on the open market but are contracts on something other than equities or ETFs, such as commodities, futures, or broad-based stock market indexes. The IRS often refers to these options as “section 1256 contracts.”
No matter how long you've held the position, Internal Revenue Code section 1256 requires options in this category to be taxed as follows:
- 60% of the gain or loss is taxed at the long-term capital tax rates
- 40% of the gain or loss is taxed at the short-term capital tax rates
Note: The taxation of options contracts on exchange traded funds (ETF) that hold section 1256 assets isn't always clear. Consult with a tax professional if you hold these types of investments.
In addition to the 60/40 split rule, if you hold section 1256 options contracts through the end of a calendar year and into the new year, you'll be required to recognize an unrealized gain or loss for each year based on the fair market value on Dec. 31. This is known as the marked-to-market rule, and it applies even if you don't sell that option. This activity also resets your cost basis (higher or lower) for the next calendar year. In addition, section 1256 contracts are not subject to the same wash sale rules as equity options.
Bottom line
These tax rules as just some of the basics. Because the taxation of options can be complex, we recommend options traders consider working with a tax professional who has experience with these types of investments.
