Options are a versatile way to trade the market, offering traders flexibility and potential profits. However, when tax season rolls around, navigating the taxation of options can become a complex process. How options are taxed varies based on factors like the option type, whether you’re buying or selling, and how long you’ve held the position. Even advanced strategies involving multiple options can further complicate the tax implications.
At Options Alerts, we’re here to simplify the process. This guide will cover how options are taxed and highlight the key details you need to know to stay compliant and maximize your returns.
How Are They Taxed?
Options trading allows investors to speculate on price movements, hedge existing positions, or generate income, making it a versatile tool in financial markets. Unlike buying or selling traditional stocks, trading options involve contracts that grant the right but not the obligation to buy or sell an asset at a specified price before a specific date. This flexibility makes options attractive to traders, but it also introduces complexity regarding taxation.
When settling your tax obligations, options are treated differently depending on their type, and understanding these differences is critical for investors. Options can be categorized into employee stock options and publicly traded options. Employee stock options are typically part of a compensation package and come with unique tax rules based on vesting periods, the exercise price, and holding periods. Publicly traded options, on the other hand, are contracts traded on exchanges that any investor can buy or sell. This article focuses on the latter, specifically options on stocks and ETFs.
For publicly traded options, tax treatment varies further based on how the option is used. Suppose you’re buying a call option to speculate on a stock’s rise or selling a put option for income. In that case, how these are taxed depends on whether you hold the option to expire, close the position early, or exercise the option. These decisions impact whether you owe short-term or long-term capital gains taxes and how the premium (the price paid or received for the option) affects your cost basis or proceeds.
Multi-leg or advanced strategies, which involve combining multiple options, add another layer of complexity. Trades like straddles, covered calls, or married puts often have unique tax treatments, making it essential to understand the specific rules that apply. Even the wash-sale rule, which prevents investors from claiming a loss if they repurchase the same or a similar asset within 30 days, can come into play with options.
Taxes on Single-Leg Options
Taxes on Purchased Options
When selling an option or when an option expires: Similar to stock transactions, the holding period at the time of sale determines the applicable tax rate. If you hold the option for more than one year, any profit will qualify for the favorable long-term capital gains tax rate. Conversely, if the holding period is less than one year, the gains will be taxed as ordinary, typically higher income. In cases where the option expires without being exercised, the same rules apply, with the holding period remaining the key factor.
Taxes When Exercising Option: You are not required to pay taxes immediately. Instead, the cost you paid to purchase the option is added to the cost basis of the stock. This directly impacts the calculation of gains or losses when you sell the stock in the future. The stock’s holding period after exercising the option determines whether the gain or loss is classified as short-term or long-term, which determines the applicable tax rate.
For put options, the situation is similar. When you exercise a put option to sell stock, the proceeds from the sale are reduced by the cost of purchasing the option. At the time of exercising the option, no taxes are due. However, when reporting gains or losses, the stock’s holding period remains the determining factor for whether short-term or long-term tax rates will apply.
Taxes on Sold Options
Tax Implications When Selling or Exercising Options: If you’ve sold a call or put and closed the position or the option has been exercised, the resulting gain or loss is considered short-term, regardless of how long you held the option. It is taxed at ordinary income rates, typically higher than capital gains rates. Similarly, if the short call or put expires without exercise, the gain is treated as a short-term capital gain and subject to ordinary income tax rates.
The tax treatment changes if the option is exercised: If your short call option is exercised, the premium received is added to the proceeds from the stock sale. The stock’s holding period will then determine whether any capital gain is classified as short-term or long-term.
When a short put option is exercised, the premium you receive reduces the cost basis of the stock you’re required to purchase. No tax is due when exercising the option, but the stock’s holding period begins when you buy it. This holding period determines whether the capital gain or loss will be classified as short-term or long-term upon selling the stock.
Taxes on Multi-Leg Options
Straddle Rules
The IRS defines a straddle as a combination of puts and calls with the same strike price and any strategy involving offsetting positions designed to minimize risk. This includes strategies like iron condors, iron butterflies, and credit spreads.
For example, if a trader buys a call option and sells a put option on the same stock, losses from the losing leg may be deferred under the IRS straddle rules until all related positions are closed.
Wash Sale Scenario
Any losses will not be immediately deductible if a strategy like an iron butterfly is adjusted (rolled) within 30 days before or after being sold. Instead, they will be deferred until all positions within the strategy are completely closed and there are no equivalent transactions within the subsequent 30 days.
For example, suppose you open an iron butterfly strategy in August, then adjust (roll) it to September, and roll it again to October. In this case, any losses incurred from the August iron butterfly trade will be deferred because the new position is considered a “successor position” (a replacement position). When you roll to October, the wash sale rule still applies. All profits or losses from this strategy will be consolidated when all related positions are fully closed and the 30-day period following the final trade has elapsed.
The 1256 Contract
Section 1256 Contracts are financial contracts, such as options and futures, governed by Section 1256 of the U.S. Tax Code. These contracts include securities index options, futures options, and other financial instruments that are not stocks. Section 1256 contracts are marked to market at the end of the year, and the profits earned from them are split into 60% long-term and 40% short-term capital gains, regardless of how long the position is held.
This provides a significant tax advantage, helping investors save on taxes compared to traditional securities trades, where the profits are taxed entirely at short-term rates unless they meet the long-term holding criteria. Section 1256 contracts help investors optimize post-tax profits, especially when engaging in options or futures trades and can be an effective tool for long-term investment strategies.
