The taxation process of traditional securities such as stocks, bonds, or commodities are fairly easy to understand.
Short-term income such as dividends or coupon payments is usually taxed at the income tax level and capital gains are taxed depending on the holding period (short-term or long-term capital gains).
For options, the IRS has come up with a different set of rules since options trading involves more complex transactions and the financial results obtained from derivatives, including options, are more difficult to estimate.
For that reason, I decided to compile a quick guide to understand taxation for options to help you in making sure you are adequately treating the results you obtain from trading options.
Taxes for Option Sellers
Option sellers are individuals or institutions that sell options and generate premium income. Writers collect a premium for selling both calls and puts and this premium must be reported as a short-term capital gain if the instrument expires worthless.
Nevertheless, if the writer buys back a put or a call option, he has to calculate the difference between the amount paid to buy it back minus the collected premium.
If the resulting figure is negative, then the writer will report a short-term loss. In turn, if the result is positive, the buyer will have to report the profit as a short-term gain.
Additionally, the holding period of the option is not important from the writer’s standpoint.
Regardless of how long it took for the option to expire the writer has to report the result as a short-term gain/loss as described above.
Finally, if the options are exercised, the writer must increase, if it is a call option, the amount reported from the sale of the stock by the amount obtained from the sale of the option.
If instead, it is a put option, the writer must reduce the cost basis of the stock by the amount received from selling the put.
Taxes for Option Buyers
Option buyers are individuals or institutions that buy calls or puts from option writers.
They can either hold the options until their expiration date or they can sell them before the maturity date is reached. In this sense, certain taxation details that have to be considered.
For Stock Options
If the holder sells a put or a call the difference between the amount obtained from the sale and the amount paid to buy it must be treated as a capital gain regardless of the holding period.
If the option expires worthless the transaction must be treated as a capital loss. On the other hand, if the option expires in the money, the holding period was 365 days or less then the result of the transaction (gain or loss) will be taxed at the short-term capital gain rate.
Instead, if the holding period is longer than 365 days, the result obtained from the operation must be taxed at the long-term capital gain rate.
Finally, if the option is exercised, the buyer must add the cost of the call option to the cost basis of the stock or deduct the cost of the put from the amount obtained from the sale of the stock.
For ETF, Indexes, and Non-Equity Options
The IRS decided to apply a different set of rules for these financial instruments and they actually benefit traders.
- Short-term transactions are taxed by following the 60/40 rule. This rule states that 60% of the result must be taxed as long-term capital gains/losses and the remaining 40% must be taxed as short-term capital gains/losses regardless of the holding period.
- They must be reported through a separate form (IRS Form 6781).
- Excess losses can be carried forward for an indefinite period of time.
- If the options are carried for a period longer than 365 days, the results from the operation may be taxed as a long-term capital gain instead of the 60/40 rule.
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.