How Are Futures and Options Taxed?

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How Are Futures and Options Taxed?

While the world of futures and options trading provides exciting opportunities to generate big gains, prospective futures or options traders should be aware with the tax regulations governing these derivatives.

This essay will provide an overview of the complicated world of options tax regulations as well as the not-so-complex requirements for futures. However, the tax rules for both of these kinds of instruments are quite complicated, and the reader is advised to contact with a tax specialist before beginning their trading trip.

Key Takeaways

  • Section 1256 of the Internal Revenue Code grants futures traders preferential tax treatment over stock dealers, resulting in a maximum total tax rate of 26.8%.
  • The tax treatment of options is even more complicated than that of futures contracts, where authors and purchasers face long-term or short-term capital gains.
  • The wash-sale regulations do not apply to futures traders, but they do to option traders.
  • Options traders must also consider straddle rules.

Tax Treatment of Futures

Section 1256 of the Internal Revenue Code provides futures traders with preferential tax status over stock trading (IRC).1256 provides that any futures contract traded on a U.S. exchange, foreign currency contract, dealer equities option, dealer securities futures contract, or nonequity options contract is taxed at 60% of long-term capital gains rates and 40% of short-term capital gains rates, regardless of how long the trade was open for. The highest overall tax rate is 26.8% since the maximum long-term capital gains rate is 20% and the maximum short-term capital gains rate is 37%.

Section 1256 contracts are likewise marked to market at the end of each year; traders may report all realized and unrealized profits and losses, and they are not subject to wash-sale regulations.

For example, in February 2021, Bob purchased a $20,000 contract. If the fair market value of this contract is $26,000 on December 31 (the final day of the tax year), Bob will record a $6,000 capital gain on his 2021 tax return. The $6,000 will be taxed at a 60/40 split.

Bob sells his contract for $24,000 a year later. In this case, Bob will record a $2,000 loss when he exits the position in 2022 since he marked his portfolio to market at the conclusion of the 2021 year and recognized a $6,000 gain.

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If a futures trader wishes to carry back any losses under Section 1256, they may do so for up to three years, provided that the losses brought back do not exceed the preceding year’s net profits or raise an operational deficit from that year. The loss is initially carried back to the first year, and any residual amounts are carried forward to the following two years. The 60/40 rule applies as normal. In contrast, if any unabsorbed losses remain after the carry-back, they may be carried forward.

Tax Treatment of Options

The tax treatment of options is even more complicated than that of futures. Both call and put writers and purchasers may face long-term or short-term capital gains, as well as wash-sale and straddle regulations.

Options traders who purchase and sell back their options at profits or losses may be taxed on a short-term or long-term basis, depending on whether the deal lasted shorter than a year. If an option that was previously purchased expires unexercised, the buyer will suffer a short- or long-term capital loss, depending on the overall holding duration.

Option writers will realize profits in the short or long term, depending on the conditions when they close out their holdings. Several things may happen if they execute the option they wrote:

  • If the written option was a naked call, the shares would be called away, and the premium collected would be added to the share price. Because this was a naked option, the transaction would be taxed in the near term.
  • If the written option was a covered call with strikes in or near the money, the call premium would be added to the selling price of the shares, and the transaction would be taxed as either a short-term or long-term capital gain, depending on how long the writer of the covered call owned the shares prior to option exercise.
  • If the covered call was made for an in-the-money strike, the writer may be required to claim short- or long-term capital gains, depending on whether the call was qualified or unqualified.
  • If the written option was a put and it was executed, the writer would simply deduct the put premium from their average share cost. Again, depending on how long the transaction is open from the time of option exercise/acquisition of shares to when the writer sells back the shares, the trade may be taxed on a long-term or short-term basis.
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If an option expires unexercised or is purchased to close, it is viewed as a short-term financial gain for both put and call writers.

When a buyer exercises an option, the procedures are significantly less cumbersome, although there are still peculiarities. When a call option is executed, the option premium is added to the cost basis of the shares the buyer is now long in. Depending on how long the buyer retains the shares before selling them back, the transaction will be taxed either short or long term.

A put buyer, on the other hand, must verify that they have held the shares for at least a year before acquiring a protective put; otherwise, short-term capital gains would be taxed. In other words, even if Sandy has held her shares for eleven months, purchasing a put option negates her whole holding period, and she now needs to pay short-term capital gains.

The Internal Revenue Service (IRS) has provided the following table detailing the tax regulations for both purchasers and sellers of options:

Wash-Sale Rules

While futures traders are exempt from the wash-sale regulations, option traders are not so lucky. Losses on “substantially similar” securities cannot be carried forward within a 30-day period under the wash-sale rule. In other words, if Mike loses some shares, he cannot apply the loss to a call option on the same stock within 30 days after the loss. Instead, Mike’s holding period will begin on the day he sold the shares, and the call premium, as well as the loss from the initial sale, will be added to the cost basis of the shares if the call option is exercised.

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Similarly, if Mike loses an option and then buys another option on the same underlying stock, the loss is added to the premium of the second option.

Straddle Rules

Straddles are a wider notion for tax reasons than the standard options straddle involving a call and put at the same strike. Straddles are defined by the IRS as holding opposing positions in comparable securities to reduce risk of loss since the instruments are projected to fluctuate inversely to market movements. If a straddle is deemed “basic” for tax reasons, losses on one leg of the trade are only reported on the current year’s taxes to the degree that they balance an unrealized gain on the opposite position.

In other words, if Alice enters a straddle position on XYZ in 2022 and the stock falls, and she decides to sell back her call option for a $8 loss while keeping her put option (which now has an unrealized gain of $5), she can only recognize a loss of $3 on her 2022 tax return—not the entire $8 loss from the call option. If Alice had chosen to “identify” this straddle, the whole $9 loss on the call option would be added to the cost basis of her put option. The IRS has published a set of guidelines for identifying straddles.

The Bottom Line

While the tax reporting procedure for futures seems to be simple, the same cannot be said for the tax treatment of options. If you are considering trading or investing in any of these derivatives, you must first get acquainted with the complex tax restrictions that await you. Many tax processes, particularly those involving options, are outside the scope of this article, and this reading should only be used as a starting point for further research or contact with a tax specialist.

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