Depending on the situation, how long you’ve held them, and the specifics, profits and losses on puts and calls may be regarded as income tax or capital gains.
Before you start trading options, you should familiarize yourself with the fundamentals of tax regulations since you will eventually have to pay taxes.
Exercising Options
Depending on how long you’ve kept your options, you may have to pay income tax or capital gains tax when you exercise them.
It all depends on the kind of option you exercise as to how much is taxed.
Call Options
The premium paid for call options is subtracted from the purchase price of the stock when the option is exercised.
As an example, a trader purchases a call option with a $20 strike price and a June expiration for Company ABC.
Because each option contract represents 100 shares, the trader purchases the option for $1, or $100 total.
When the option expires, the trader exercises it, and the stock trades at $22. $2,100 serves as the cost foundation for the whole purchase.
That comes to $2,100 ($20 x 100 shares) plus the $100 premium.
Assume that in August, the share price of Company ABC is $28.
The trader chooses to liquidate their holdings. $700 is recognized as a taxable short-term capital gain.
The $2,800 in revenues less the $2,100 cost basis is $700 (commissions may be deducted, but not in this instance).
Given that the trader held the investment for less than a year—exercising the option in June and selling the position in August—the earnings from the sale are regarded as short-term capital gains.
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Put Options
Put options are handled similarly. The put’s premium and commissions are added to the shares’ cost basis if the put is executed and the buyer acquires the underlying equities.
After then, the selling price of the shares is reduced by this amount.
The elapsed period for the position starts when the shares were first bought and ends when the put was executed, or when the shares were sold.
Similar tax regulations to those governing a short sale apply when a put is executed without the owner of the underlying stock having done so first.
The term begins on the day of exercise and ends when the position is closed or covered.
Warning
Note that this page just provides an overview of how options are treated tax-wise.
The tax rules pertaining to trading and options are complex. It is advised to do more research or speak with a tax expert.
Pure Options Games
For the purposes of pure options positions, the tax treatment is the same for both long and short options.
When a position is closed or expires without being used, gains and losses are computed.
All options that expire unexercised in call or put writing are seen as short-term gains.
An example covering a few common cases may be seen below.
Taylor pays $3 in May 2023 for an October 2023 put option with a $50 strike on 100 Company XYZ shares.
When Company XYZ falls below $40 in September 2023, they would be subject to taxation on short-term capital gains (from May to September) or $10 less the put’s price and related fees if they sell back the option.
Taylor’s $700 short-term capital gain ($50 – $40 strike – $3 premium paid x 100 shares) would be subject to taxation in this scenario.
Taylor is eligible for a short-term capital loss of $600 ($70 – $60 strike – $4 premium received x 100 shares) if they write a $60 strike call for 100 Company XYZ shares in May, receive a premium of $4 with an October expiry, and choose to buy back their option in August when Company XYZ jumps to $70 on blowout earnings.
On the other hand, Taylor will experience a long-term capital loss on their unexercised option equal to the premium of $400 ($4 x 100 shares) if they bought a $75 strike call for 100 Company XYZ shares for a $4 premium in May with an October expiry in the following year, and the call is held until it expires unexercised (let’s say Company XYZ traded at $72 at expiry).
This is because the option would have been a long-term loss for tax reasons, having been held for more than a year.
Covered Calls
Going long or short on a call is not as complicated as covered calls.
A covered call limits potential upside but generates premium income when someone who is already long the underlying securities sells upside calls against that position.
For at-or out-of-the-money calls, there are three possible situations for taxing a covered call:
- The call is not made.
- The call is made.
- The call is purchased again (bought-to-close).
For instance, on January 3, Taylor sells a $50 strike covered call with a September expiration and receives a premium of $0.95 since he owns 100 shares of Microsoft Corporation (MSFT), which are selling at $46.90:
Even though Taylor owned the option for more than a year, they will receive a $0.95 short-term capital gain if the call is not exercised and MSFT trades at $48 at expiry.
Regardless of the length of holding, the premium paid for a put or call option is treated as a short-term capital gain earned on the expiry date.
Taylor will see a capital gain depending on their whole holding term and complete cost if the call is executed.
Taylor would thus have a short-term financial gain of $13.95 ($50 – $36.05 or the amount they paid less the call premium received) if they had purchased shares in January for $37.
Given that the post was terminated before a year, it would only be temporary.
In the event that the call is purchased back: Taylor could be entitled to long- or short-term capital gains or losses, depending on the amount paid to buy the call back and the total amount of time that has passed since the transaction.
The example given above only applies to covered calls that are either in-the-money or out-of-the-money.
In-the-money (ITM) covered calls have even more complicated tax treatment.
Treatment that is Qualified vs. Unqualified
The trader must first ascertain if an ITM covered call is qualified or unqualified before writing one, since the latter may have unfavorable tax implications.
Even when the underlying shares have been held for more than a year, a call that is determined to be unqualified will be taxed at the short-term rate.
The requirements for qualifying may be complex, but the main thing is to make sure that the call has a term of more than thirty days before it expires and that it is not less than one striking price below the closing price of the previous day.
For instance, Taylor chose to write the June 5 $45 call, earning a premium of $2.65, despite having owned shares of Microsoft since January of last year at a price of $36 a share.
Since the expiration date is less than 30 days away, their covered call is unqualified and their shares’ holding period will be stopped.
This is because the closing price of the most recent trading day, May 22, was $46.90, meaning that one strike below that would be $46.50.
Despite having owned their shares for more than a year, Taylor will see short-term financial gains if the call is executed on June 5 and their holdings are taken away.
Protective Puts: These are somewhat more simple, but not significantly.
A trader is still eligible for long-term capital gains if they have owned shares of a company for more than a year and want to use a protective put to hedge their position.
Even with more than a month to expiration, if the trader buys a protective put after owning the shares for less than a year (let’s say eleven months), the trader’s holding term will be instantly voided. Any profits from the stock sale will only last a short while.
Regardless of how long the put has been held before the share purchase, the same holds true if shares of the underlying are acquired while holding the put option prior to the option’s expiry date.
Rule for Wash Sales
The IRS states that losses on one investment are not transferable to the purchase of an other asset that is “substantially identical” during a 30-day period.
Additionally, call options are subject to the wash sale rule.
Taylor won’t be able to recover their losses, for instance, if they sell a stock at a loss and then purchase the call option on the same stock within a thirty-day period.
Rather, the call option’s premium will be increased by Taylor’s loss, and the call’s holding period will begin on the day they sold the shares.
The call premium and the carryover loss from the shares will be included in the cost basis of their new shares when they exercise their call option.
These new shares will have a holding term that starts on the day of the call exercise.
Similarly, Taylor’s loss on the first option would be prohibited and added to the premium of the second option if he were to incur a loss on a call or put option and purchase a comparable option on the same company.
Straddles
Only the amount of tax losses on straddles that balance the profits on the opposing position is recorded.
A trader will only be allowed to claim a $200 loss on their tax return for the current year if they establish a straddle position, sell the call for a $500 loss, and have unrealized profits of $300 on the puts.
What Is The Tax On Options?
An stock option is taxed as income if it represents a short-term capital gain or loss.
Both earnings and losses are taxed as capital gains if they are long-term.
Do Covered Call Options Require Capital Gains Taxation?
Covered call profits and losses are capital gains or losses.
Does Options Trading Require Tax Reporting?
You have to notify the IRS whenever a sale results in a taxable event.
Conclusion
Although options taxes are very complicated, it is crucial that traders become well-versed in the regulations pertaining to these derivative products.
This article should only be used as a starting point for more study since it is by no means an exhaustive description of the subtleties controlling option tax treatments.
It is advisable to contact with a tax expert who has expertise with trading and investments.
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