Options trading is a popular investment strategy, but navigating the tax implications can be complex. The tax treatment of options varies depending on factors such as the type of option, whether it was bought or sold, and the holding period. Even advanced options trades can impact how they are taxed.
Here’s a breakdown of how options are taxed and key considerations to keep in mind.
Understanding Options Taxation
Options can be taxed differently based on whether they are employee stock options or publicly traded options. This article focuses on the taxation of publicly traded options on stocks and ETFs that are available to all investors on the open market.
It’s important to note that this article addresses the taxation of options trades for individual investors and not for those operating a trading business.
When it comes to single-leg trades of publicly traded options, such as buying a call or selling a put, the tax treatment is relatively straightforward. However, multi-leg advanced trades can introduce complexity into the tax calculations.
Taxation of Purchased Single-Leg Options
If you buy a call or put option and either sell it or let it expire, the tax implications are as follows:
- The holding period of the option at the time of sale determines whether it qualifies for long-term capital gains tax rates (held for more than a year) or is taxed at ordinary income rates (held for less than a year).
- If the option expires, the same holding period rule applies. A holding period of more than a year results in long-term capital gains treatment.
However, exercising the option results in a different tax treatment:
- Exercising a call option increases the cost basis of the purchased stock, with no immediate tax due. The holding period of the stock determines the capital gains tax rate.
- Exercising a put option reduces the proceeds of the stock sale by the cost of the option. The holding period of the stock dictates the tax treatment of the gain or loss.
Taxation of Sold Single-Leg Options
If you sell a call or put option and either close the position or the option is exercised, the tax implications are as follows:
- Closing a short call or put position results in a short-term gain or loss taxed at ordinary income rates.
- If the short call or put expires, it is treated as a short-term capital gain subject to ordinary income rates.
Exercising a short call or put option has its own tax treatment:
- If a short call is exercised, the option premium is added to the sale proceeds of the stock, with the stock’s holding period determining the capital gains tax rate.
- If a short put is exercised, the option premium reduces the cost basis of the stock, with the stock’s holding period determining the tax treatment of the gain or loss.
Taxation of Hedged and Multi-Leg Options Trades
Hedged options trades and multi-leg advanced trades may have different tax treatments. The IRS limits the loss an investor can claim on one side of a multi-part trade until all legs are closed. This prevents investors from deducting losses before offsetting gains are realized.
Restricted Loss Deferral
For example, if one side of a trade shows a realized loss while the other side has an unrealized gain, the IRS limits the tax loss for the current year to the difference between the two. Unused losses can be carried forward to the next tax year.
Covered-call transactions have special tax treatment to avoid loss deferral rules, provided certain conditions are met. This allows investors to take a loss on a covered call without closing the stock position.
Options and the Wash-Sale Rule
Options, like stocks, are subject to the wash-sale rule, which prohibits claiming a capital loss if the same or a substantially similar asset is repurchased within 30 days before or after the sale. Fully closing the position and staying out of it for 30 days allows the loss to be claimed on a future tax return.
Conclusion
The tax treatment of options can be intricate, especially for multi-leg trades. Investors engaging in advanced options strategies should be mindful of the tax rules to maximize their tax benefits.