Tax Treatment for Call and Put Options

Rate this post
Tax Treatment for Call and Put Options

Prior to trading options, it is essential to have a fundamental awareness of tax regulations. We will look at how calls and puts are taxed in the United States in this post. We will specifically examine exercised calls and puts, as well as options traded on their own. We’ll also go over the wash sale rule and how straddles are taxed.

Please keep in mind that the author is not a tax expert. This page should only be used as a primer on the taxation of options. More research or contact with a tax specialist is advised.

Key Takeaways

  • If you trade options, you’ve most likely triggered certain taxable events that must be reported to the IRS.
  • While many option profits will be categorised as short-term capital gains, the mechanism used to calculate the gain (or loss) will differ depending on the strategy and holding duration.
  • Exercising in-the-money options, selling a position for a profit, or participating in covered call writing all result in somewhat different tax consequences.

Exercising Options

Call Options

When call options are executed, the option price is deducted from the cost basis of the stock. Consider an investor who purchases a call option on Company ABC with a strike price of $20 and an expiration date of June 2020. The investor pays $1 for the option, or $100 altogether, since each contract represents 100 shares. When the option expires, the stock trades at $22 and the investor exercises it. The total cost basis for the purchase is $2,100. That’s $20 multiplied by 100 shares, plus the $100 premium, for a total of $2,100.

Assume it is August 2020, and Company ABC is now trading at $28 per share. The investor chooses to liquidate their holdings. A $700 taxable short-term capital gain is achieved. That is $2,800 in revenues less $2,100 in cost basis, or $700.

We shall exclude commissions, which may be included in the cost base, for the purpose of brevity. Due to the fact that the investor exercised the option in June and sold the position in August, the transaction is deemed a short-term capital gain since the investment was held for less than a year.

Put Options

Put options are treated similarly. If a put is executed and the buyer owns the underlying securities, the premium and fees are added to the share’s cost basis. This amount is subsequently deducted from the share price. The elapsed period for the position starts when the shares were first acquired and ends when the put was executed (i.e., when the shares were sold).

  What Is the OIS LIBOR Spread, and What Is It for?

When a put is executed without previous ownership of the underlying stock, the tax requirements are identical to those of a short sale. The time period begins with the exercise date and concludes with the position being closed or covered.

Pure Options Plays

For the purposes of pure options positions, both long and short options get comparable tax treatment. When positions are closed or expire unexercised, gains and losses are computed. All options that expire unexercised in the event of call or put writing are considered short-term gains. An illustration of various fundamental circumstances is provided below.

Taylor pays $3 in May 2020 for an October 2020 put option on Company XYZ with a $50 strike. If they later sell the option when Company XYZ falls to $40 in September 2020, they will be taxed on short-term capital gains (May to September) or $10 less the put price and related charges. Taylor would be taxed on a $700 short-term capital gain in this situation ($50 – $40 strike – $3 premium paid x 100 shares).

If Taylor sells a $60 strike call on Company XYZ in May, receives a $4 premium, and chooses to buy back their option in August when Company XYZ climbs to $70 on blowout profits, they are entitled for a $600 short-term capital loss ($70 – $60 strike + $4 premium received x 100 shares).

If, on the other hand, Taylor purchases a $75 strike call for Company XYZ for a $4 premium in May 2020 with an October 2021 expiration, and the call is kept until it expires unexercised (say, Company XYZ trades at $72 at expiry), Taylor would incur a long-term capital loss equivalent to the $400 premium. This is because he would have held the option for more than a year, resulting in a long-term tax loss.

Covered Calls

Covered calls are more complicated than just going long or short on a call. A covered call is sold by someone who is already long the underlying securities in order to generate premium income while restricting upside potential. For at or out-of-the-money calls, taxing a covered call may fall into one of three categories:

  1. Call is unexercised
  2. Call is exercised
  3. The call has been repurchased (bought-to-close)

For example:

  • Taylor acquires 100 shares of Microsoft Corporation (MSFT) at $46.90 on January 3, 2019, and writes a $50 strike covered call with a September 2020 expiration, earning a premium of $0.95.

  1. If the call is not exercised, and MSFT trades at $48 at expiry, Taylor will achieve a $0.95 short-term capital gain on their option, despite holding it for more than a year. When a put or call option expires, regardless of the holding period, you consider the premium payment as a short-term capital gain realized on the expiry date.
  2. If Taylor exercises the call, they will achieve a capital gain based on their entire position time period and total cost. Taylor will make a short-term financial gain of $13.95 ($50 – $36.05 or the amount they paid less the call premium received) if they buy shares in January 2020 for $37. Because the post was closed prior to one year, it would be temporary.
  3. Taylor may be entitled for long- or short-term capital gains/losses if the call is purchased back, based on the amount paid to buy the call back and the total time period elapsed for the exchange.
  Best Times to Trade the Forex Markets: A Guide

The above example only applies to at-the-money or out-of-the-money covered calls. The tax treatment of in-the-money (ITM) covered calls is even more complicated.

Qualified vs. Unqualified Treatment

When writing ITM covered calls, the investor must first evaluate if the call is qualified or unqualified, since the latter has negative tax implications. Even though the underlying shares have been held for more than a year, if a call is judged unqualified, it will be taxed at the short-term rate. The eligibility rules may be complicated, but the objective is to ensure that the call is not more than one striking price lower than the previous day’s closing price, and that the call has a time period of more than 30 days till expiration.

Taylor, for example, has owned shares of MSFT since January of last year at $36 a share and chooses to write the June 5 $45 call for a $2.65 premium. Because the latest trading day’s closing price (May 22) was $46.90, one strike lower would be $46.50, and because the expiration is less than 30 days away, their covered call is unqualified, and their shares’ holding period would be stopped. If the call is exercised on June 5 and Taylor’s shares are called away, Taylor will enjoy short-term financial gains despite owning their shares for more than a year.

Protective Puts

Protective puts are a bit easier to understand, but only just. If an investor has owned a stock for more than a year and wishes to safeguard their position with a protective put, the investor is still eligible for long-term capital gains. Though the shares have been held for less than a year (say, eleven months) and the investor acquires a protective put, even if the expiration date is still more than a month away, the investor’s holding period is instantly nullified, and any profits on sale of the stock are short-term gains.

  Why Open Interest and Trading Volume Matter to Options Traders

The same is true if shares of the underlying are acquired while holding the put option prior to its expiry date, regardless of how long the put has been held previous to the share purchase.

Wash Sale Rule

Losses from one security cannot be carried over to the purchase of another “substantially comparable” security within a 30-day period, according to the IRS. The wash sale rule also applies to call options.

For example, if Taylor makes a loss on a stock and then purchases a call option on the same stock within thirty days, they will be unable to claim the loss. Taylor’s loss will instead be added to the call option premium, and the call’s holding period will begin on the day they sold the shares.

When they exercise their call, the cost basis of their new shares will contain the call price as well as the share’s carryover loss. The holding period for these additional shares will commence on the day of the call exercise.

Similarly, if Taylor loses a call or put option and then buys a comparable option on the same stock, the loss from the first option is permitted and added to the premium of the second option.

Straddles

Finally, we’ll look at how straddles are taxed. Straddle tax losses are recorded solely to the degree that they balance profits on the opposite position. If an investor enters a straddle position and sells the call at a loss of $500 but has unrealized profits of $300 on the puts, the investor may only claim a $200 loss on their tax return for the current year.

The Bottom Line

Taxes on options are quite complicated, yet it is critical that investors become well-versed in the regulations that govern these derivative securities. This article is not a comprehensive exposition of the subtleties controlling option tax treatments and should only be used as a starting point for future study. Please consult a tax expert for a comprehensive list of tax intricacies.

You are looking for information, articles, knowledge about the topic Tax Treatment for Call and Put Options on internet, you do not find the information you need! Here are the best content compiled and compiled by the achindutemple.org team, along with other related topics such as: Trading.

Similar Posts