Options trading is becoming more popular among investors, yet a lot of people don’t understand the tax implications of these transactions. Investors may be surprised by how complex the taxation of options can be. Let’s look at the key factors you need to consider when it comes to buying and selling options on the open market.
The language of taxes versus investing
The IRS has its own lingo when it comes to investing, which doesn’t match up perfectly with the language used within the financial industry. Though many people may consider themselves to be “traders” (aka day traders or active traders), to the IRS, you’re likely just seen as an “investor.” To be considered a trader by the IRS you must be in the “business of trading,” which basically means trading is your day job.
This article will focus on the tax implications of buying and selling options for “investors.” For those who feel they may qualify as being in the “business of trading,” we recommend meeting with a tax professional and reading the following IRS resources, IRS publication 550 and IRS Topic No. 429 Traders in Securities.
Categories of options
For tax purposes, options can be classified into three main categories:
- Employee stock options: These are generally options contracts given to employees as a form of compensation. For example, incentive stock options.
- Equity options: Options contracts on equities that can be traded on the open market. For example, puts or calls on individual stocks or on ETFs that hold stocks.
- Non-equity options: As the name infers, these are options contracts on something other than equities or ETFs, which can include commodities, futures or a broad-based stock market index. The IRS often refers to these options as “section 1256 contracts.” These types of options can also be traded on the open market. Examples include puts or calls on gold, pork belly futures, and even the S&P 500 index (more on this later).
Taxation of employee stock options
Though employee stock options aren’t traded on the open market, they are a common form of option held by many people. Here are a few high-level points you should know about them. These option contracts are usually granted by an employer to attract new employees, or to reward and retain current ones. There are two primary types of employee stock options: 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 be either treated as ordinary income or can be 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” and “Understanding the Risks of Employee Stock Options.”
Taxation of equity options
The taxation of equity options is different for a long position (where you’re the buyer of the option) versus a short position (where you’re the seller/writer of the option). For those who have long or short options contracts, the tables below provide an overview of how these contracts are generally taxed. But be aware, if you’re doing more complex options transactions, such as spreads or butterflies, the IRS may consider those trades to be “straddle” contracts, which means they could be taxed differently (see below for more details).
- Long Options (buy)
- If position is closed before the expiration
- If you exercise the option
- If the option expires
Long Options (buy)Long Call>If position is closed before the expirationThe holding period of the option determines if it's taxed at short- or long-term capital tax rates.>If you exercise the optionExercising a call option increases the cost basis of the stock purchased. There is not a taxable event until stock is sold, and the hold period of the stock determines if the capital gain or loss is short- or long-term.>If the option expiresThe holding period of the option determines if the capital loss is short- or long-term.>
Long Options (buy)Long Put>If position is closed before the expirationSame as above.>If you exercise the optionExercising a put option reduces the amount realized from the sale of the underlying stock by the cost of the put.>If the option expiresSame 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 Options (sell/write)Short Call>If position is closed before the expirationRegardless of holding period, the capital gain or loss is always considered short-term.>If the option is exercised (assigned to you)The amount you received for writing the option increases the amount received from the sale of the stock. Depending on your holding period of the stock, the capital gain or loss is short- or long-term.>If the option expiresReport the amount received for writing the option as short-term capital gain.>
Short Options (sell/write)Short Put>If position is closed before the expirationSame as above.>If the option is exercised (assigned to you)If the put option is exercised and you buy the underlying stock, decrease the cost basis in the stock by the amount received for writing the option. Your holding period for the stock begins on the date you buy it.>If the option expiresSame as above.>
Taxation of complex equity options strategies
Numerous options strategies are available to investors, such as writing covered calls, using spreads, straddles, strangles, butterflies, etc. Unfortunately, this is another situation where the IRS does not use the same language as investors, and that can lead to some confusion. 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’re holding an options contract that offsets or substantially reduces the risk of loss to another position you’re also holding. For example, say you own stock in XYZ corporation and that stock in currently trading for $80 per share. If you bought a put option at a $70 strike price to protect against downside price movement, you have in essence limited your down-side risk, which means the IRS would consider that option to be a straddle and you must defer your loss (cost) on the put option. The idea behind the straddle taxation rules is to prevent investors from deducting losses before an offsetting gain is recognized.
Here are the basics you need to know about how straddles are taxed:
- Losses on straddles are generally deferred: If only one side of a straddle position is closed, any realized losses are generally not deductible until the offsetting position is also closed out. Any losses are included in the basis of the remaining position and eventually recognized when the final position is closed. 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, unqualified or qualified, 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 does not 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 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.
Non-equity options taxation
Internal Revenue Code section 1256 requires options contracts on futures, commodities, currencies and broad-based equity indices to be taxed at a 60/40 split between the long and short term capital gains rates. This rule means the taxation of profits and losses from non-equity options are not affected by how long you hold them. Section 1256 options are always 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 is not 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 over year-end into the new year, you’ll be required to recognize an unrealized gain or loss 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.
The taxation of options can be even more complex than what was described above. That’s why we recommend that anyone who trades options consider working with a tax professional who has experience in options taxation so that you don’t end up paying more in taxes than is necessary.