It is very important for traders to understand the tax laws on stock option trading. Let’s begin by defining some stock option terms.
Option Holder – a person who holds either a put option or a call option position.
Put Option – gives the holder the right to sell a specific stock at a set price (“the strike price”) on or before a specific date.
Call Option – gives the holder the right to buy a security at a set price on or before a specific date.
Option Writer – a person who grants someone else a put or a call option in return for a premium (a fee received) from the holder in return for taking the risk. The premium will be in direct correlation to the risk, the more risk taken, the higher the premium collected.
Covered Call – A call option that is sold against stock owned by the writer of the call.
Protective Put – A put option bought to hedge a long stock position. involves being long the underlying stock and purchasing a put option with a strike price that is near the underlying stock’s current price
Straddle – Simultaneous long or short positions of puts and calls having the same underlying security and same strike price.
Now that you are familiar with the terminology, let’s discuss stock options and tax treatment in more detail.
If you hold options they will either:
expire unexercised on the expiration date because they are worthless
be exercised because they are “in the money” or
be sold before they expire.
In outcome 1, you have sustained a capital loss which equals the premium you paid. Usually the loss would be short term because you held the stock option for one year or less.
In outcome 2, if you exercise a put option by selling stock to the writer at the designated price, deduct the option cost (the premium plus any transaction costs) from the proceeds of your sale. Your capital gain or loss is long term or short term depending on how long you owned the underlying stock. Enter the gain or loss on Form 8949, just as you would for any stock sale.
In outcome 3, if you sell your option things are simple. You have a capital gain or loss that is either short term (a year or less) and taxed at ordinary income tax rates, or long term (more than a year).
The premium received has no tax consequences for the option writer until the option:
is exercised or
is offset in a “closing transaction”
In outcome 1, when a put or call option expires, you treat the premium payment as a short-term capital gain realized on the expiration date. This is true even if the duration of the option exceeds 12 months. If you wrote the option in the year before it expires there are no tax consequences in the earlier year.
In outcome 2, if you write a put option that gets exercised (meaning you must buy the stock), reduce the tax basis of the shares you acquire by the premium you received. Your holding period starts the day after you acquire the shares. If you write a call option that gets exercised (meaning you sell the stock), add the premium to the sales proceeds. Your gain or loss is short term or long term depending on how long you held the shares.
In outcome 3, with a closing transaction, your economic obligation under the option you wrote is offset by purchasing an equivalent option. For example, say you write a put option for 1,000 shares of ABC Corp. at $40 per share with an expiration date of September 5, 2017. While this obligates you to buy 1,000 shares at $40, it can be offset by purchasing a put option for 1,000 shares at $40 per share. You now have both an obligation to buy (under the put option you wrote) and an offsetting right to sell (under the put option you bought). For tax purposes, the purchase of the offsetting option is a closing transaction because it effectively cancels the option you wrote. Your capital gain or loss is short term and is equal to the difference between the premium you received for writing the option and the premium you paid to enter into the closing transaction. The gain or loss must be reported in the tax year you make the closing transaction.
Covered Calls and Protective Puts
Covered calls are more complex than simply going long or short a call and can fall under one of three scenarios for at or out-of-the-money calls:
call is unexercised
call is exercised
call is bought back (bought-to-close)
Unexercised Covered Call Example
Jacob owns 100 shares of INTC currently valued at $46.90 and he writes a $50 strike covered call with a September expiration, receiving a premium of $.95. If the call goes unexercised, Jacob will realize a short-term capital gain of $.95 on his option.
Exercised Covered Call Example
If the call is exercised, assuming he bought the shares in January of 2014 for $37, Jacob will realize a long-term capital gain of $13.95 ($50 – $36.05 or the price he paid minus call premium received).
Bought Back Covered Call Example
If the call is bought back, depending on the price paid to buy the call back and the time period elapsed in total for the trade, Jacob may be eligible for long- or short-term capital gains/losses.
**The above example pertains strictly to at-the-money or out-of-the-money covered calls. Tax treatments for in-the-money (ITM) covered calls are vastly more intricate and will be covered in a future article.
If an investor has held shares of a stock for more than a year and wants to protect their position with a protective put, he or she will still be qualified for long-term capital gains. If the shares had been held for less than a year, say eleven months, and if the investor purchases a protective put- even with more than a month of expiration left, the investor’s holding period will immediately be negated and any gains upon sale of the stock will be short term gains. The same is true if shares of the underlying stock are purchased while holding the put option before the option’s expiration date—regardless of how long the put has been held prior to the share purchase.
Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. For example, if Moses were to enter a straddle position and disposes of the call at a $500 loss, but has unrealized gains of $300 on the puts, Moses will only be able to claim a $200 loss on the tax return for the current year.
The Bottom Line
Taxes on stock options are complex, it is imperative that investors build a strong familiarity with the rules governing these derivative instruments. We highly suggest seeking professional tax advice such as that provided by the experts at OTA Tax Pros.