Options are a popular way to trade the market, but dealing with them at tax time can be less than straightforward. Options are not always treated the same for tax purposes, and the capital gains tax can differ depending on the type of option, whether you buy it or sell it and the holding period. Even combining an option with others in an advanced options trade can affect how it’s taxed.
Here’s how options are taxed and key things to know about how your taxes will be assessed.
How are options taxed?
Options can be taxed in various ways, depending on the type of option: employee stock options or publicly traded options. This article deals with taxation of publicly traded options on stocks and ETFs, the kind that any investor can buy on the open market from a typical options broker.
Importantly, this article deals with how options trades are taxed for those who are not running a business in options trading. Those running a trading business are subject to different treatments.
The taxation on single-leg trades of publicly traded options — for example, buying a call or selling a put — is straightforward, though it can differ depending on whether you’ve bought or sold the option. Taxation on multi-leg advanced trades can become more complex, however.
Taxes on single-leg options you’ve purchased
If you’ve bought a call or put option and sold it or the option expires, the tax calculation is straightforward:
- Just as with stocks, the holding period at the time of sale determines how the option is taxed. A holding period of longer than a year qualifies it for long-term capital gains tax rates. Anything less and taxes are assessed at (normally higher) ordinary income rates.
- If the option expires, the same determination as above applies. If the total period was more than a year, then it gets the preferential long-term tax rate. Otherwise, no.
The treatment is different if you exercise the option, however:
- If you exercise a call, the price of the option increases the cost basis of the stock that you purchase. No tax is due when the option is exercised, and the holding period of the stock determines whether the capital gain is short term or long term.
- If you exercise a put, the proceeds of the stock sale are reduced by the cost of the option. The stock’s holding period determines whether it’s a short- or long-term gain or loss.
Taxes on single-leg options you’ve sold
If you’ve sold a call or put and closed the position or the option has been exercised, here’s how it’s taxed:
- If you’ve closed the short call or put position, it’s treated as a short-term gain or loss, regardless of how long you’ve held it. It’s subject to ordinary income rates.
- If the short call or put expires, it’s treated as a short-term capital gain, and is subject to ordinary income rates.
The treatment also differs if the option is exercised:
- If your short call has been exercised, then the option premium is added to the proceeds from the sale. The stock’s holding period determines whether the capital gain or loss is short term or long term.
- If your short put has been exercised, then the option premium reduces your cost basis in the stock. No tax is due when the option is exercised, and the holding period of the stock begins when you purchase the stock. The ultimate holding period of the stock determines whether the capital gain is short term or long term.
Taxes on hedged and multi-leg options trades
Hedged options trades such as some beginning option strategies and multi-leg advanced trades — those with two or more parts — are often subject to different treatments. Even basic strategies such as the covered call and the married put can require some additional steps to figure the tax.
Generally, the rules here aim to keep investors from deducting losses before a corresponding and offsetting gain is recognized.
Restricted loss deferral
The IRS limits the loss an investor can claim on one side of a multi-part trade until the various legs are finally closed. The IRS states: “Generally, you can deduct a loss on the disposition of one or more positions only to the extent the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.”
For example, you have a two-part trade, with one side showing a realized loss of $20,000 and the other an unrealized gain of $18,000 at year-end. The IRS rule limits the tax loss for the current year to the $2,000 difference between the two. Later, when the other leg of the trade is closed, the previously realized loss can offset the (presumed) gain or increase the capital loss.
For IRS purposes, this treatment prices the unrecognized gain as of the last business day of the tax year at fair market value.
Covered-call transactions
A covered call is a transaction in which the investor owns the underlying stock and then sells a call option against that stock. A special tax treatment of covered calls can help investors avoid the loss-deferral rules above, though the covered call must meet a few conditions to be considered a qualified covered call, including:
- The short call must have an expiration longer than 30 days.
- The option’s strike price is not “deep in the money.”
If the covered call doesn’t meet all the requirements, then it’s not qualified and is subject to the loss-deferral rules.
The covered-call rules allow those who sell covered calls to take a loss on the call without having to close out the corresponding stock position. That’s especially beneficial for investors who have a substantial unrealized gain in a stock that would be subject to tax if the stock had to be sold.
A special provision applies for qualified covered calls in some cases. If an investor writes a qualified covered call with a strike price less than the stock price, a loss on the call is treated as a long-term capital loss if a sale of the stock would be treated that way. However, the stock’s holding period does not include any time that the investor had written the call option.
Options and the wash-sale rule
Like stocks, options are also subject to the wash-sale rule, limiting how and when an investor can claim a capital loss. A wash sale occurs when an investor sells an asset for a loss but has bought the same asset or a substantially similar one within 30 days before or after the sale.
The IRS will prohibit you from claiming the loss if it’s part of a wash sale, and you’ll need to fully close the position and stay out of it for at least 30 days before you’ll be able to claim the loss.
Even if you’re subject to the wash-sale rule, you’ll eventually be able to claim the loss on a future tax return if you fully exit the position for 30 days. So you won’t lose your tax break.
Bottom line
The tax treatment of options can be complex, and it can differ depending on whether the trade is one-leg trade or part of a multi-leg trade. Investors using advanced options strategies should pay particular attention here, since the rules affect the loss they can claim in a given tax year.
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