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Comprehensive Guide:
Special Tax Rules for Options


There are specific tax rules that all options traders should understand.

This guide will explain some of the aspects of reporting taxes from options trading. We will highlight specific adjustments required when options are sold, expired, or exercised. And we will examine special rules that apply to some ETF and index options.

Contents

Tax Rules for Calculating Capital Gains from Trading Options

Calculating capital gains from trading options adds additional complexity when filing your taxes.

A stock option is a securities contract that conveys to its owner the right, but not the obligation, to buy or sell a particular stock at a specified price on or before a given date. This right is granted by the seller of the option in return for the amount paid (premium) by the buyer.

Any gains or losses resulting from trading equity options are treated as capital gains or losses and are reported on IRS Schedule D and Form 8949.

Special rules apply when selling options:

IRS Publication 550 page 60 features a table of what happens when a PUT or CALL option is sold by the holder:

When a Put: If you are the holder: If you are the writer:
Is sold by the holder Report the difference between the cost of the put and the amount you receive for it as a capital gain or loss.* This does not affect you. (But if you buy back the put, report the difference between the amount you pay and the amount you received for the put as a short-term capital gain or loss.)
When a Call: If you are the holder: If you are the writer:
Is sold by the holder Report the difference between the cost of the call and the amount you receive for it as a capital gain or loss.* This does not affect you. (But if you buy back the call, report the difference between the amount you pay and the amount you received for the call as a short-term capital gain or loss.)

Notes:

Option Expiration

All stock options have an expiration date. If an option expires, then this closes the option trade and a gain or loss is calculated by subtracting the price paid (purchase price) for the option from the sales price of the option. It doesn't matter if you bought the option first or sold it first.

If you bought an option and it expires worthless, you naturally have a loss. Likewise, if you sold an option and it expires worthless, you naturally have a gain. If your equity option expires, you generated a capital gain or loss, usually short-term because you held the option for one year or less. But if it was held longer, you have a long-term capital loss.

IRS Publication 550 page 60 features a table of what happens when a PUT or CALL option expires:

When a Put: If you are the holder: If you are the writer:
Expires Report the cost of the put as a capital loss on the date it expires.* Report the amount you received for the put as a short-term capital gain.
When a Call: If you are the holder: If you are the writer:
Expires Report the cost of the call as a capital loss on the date it expires.* Report the amount you received for the call as a short-term capital gain

Notes:

Sounds simple enough, but it gets much more complicated if your option gets exercised.

Option Exercises and Stock Assignments

Since all option contracts give the buyer the right to buy or sell a given stock at a set price (the strike price), when an option is exercised, someone exercised their rights and you may be forced to buy the stock (the stock is put to you) at the PUT option strike price, or you may be forced to sell the stock (the stock is called away from you) at the CALL option strike price.

There are special IRS rules for options that get exercised, whether you as the holder of the option (you bought the option) exercised your rights, or someone else as the holder of the option (you sold the option) exercised their rights.

IRS Publication 550 page 60 features a table of what happens when a PUT or CALL option is exercised:

When a Put: If you are the holder: If you are the writer:
Is exercised Reduce your amount realized from sale of the underlying stock by the cost of the put. Reduce your basis in the stock you buy by the amount you received for the put.
When a Call: If you are the holder: If you are the writer:
Is exercised Add the cost of the call to your basis in the stock purchased. Increase your amount realized on sale of the stock by the amount you received for the call.

Your option position therefore does NOT get reported on Schedule D Form 8949, but its proceeds are included in the stock position from the assignment.

When importing option exercise transactions from brokerages, there is no automated method to adjust the cost basis of the stock being assigned. Brokers do not provide enough detail to identify which stock transactions should be adjusted and which option transactions should be deleted.

TradeLog software includes an Option Exercise/Assign function, allowing users to make adjustments for most exercise and assignments situations. See our User Guide for details.

Selling Puts Creates Tax Problems

Put selling, or writing puts, is quite popular in a bull market. The advantage of this strategy is that you get to keep the premium received from selling the put if the market moves in two out of the three possible directions.

If the market goes up, you keep the premium, and if it moves sideways, you keep the premium. Time decay which is inherent in all options is on your side. Quite a nice strategy.

Tax Preparation Problems

Since the focus of our site is trader taxes, and not a commentary on various option trading strategies, we will concentrate our discussion on the potential problems that this particular strategy sometimes creates when attempting to prepare your taxes from trading.

If the market heads down (one of the three possible directions), you may find yourself owning the stock as the option may get exercised and the stock gets put to you at the strike price.

IRS Publication 550 states that if you are the writer of a put option that gets exercised, you need to "Reduce your basis in the stock you buy by the amount you received for the put."

Real World Example

This may sound simple, but as usual when it comes to taxes and the real world, nothing is quite that simple as the following example will show:

With stock ABC trading above $53, Joe decides to sell ten ABC NOV 50 PUT options and collect a nice premium of $4.90 per contract or $4,900.00. With current support at $51.00 and less than 5 weeks till expiration, these options should expire worthless and Joe keeps the premium.

In addition, Joe is profitable all the way down to $45.10 ($50.00 - $4.90). So far so good.

But unexpectedly, the market goes against Joe, and ABC drops below the $50 range. Joe is still profitable but he is now open to the option being exercised and the stock being assigned or put to him at $50.

Here is where the fun starts: If all ten of the option contracts get exercised, then 1,000 shares get put to him at the strike price of $50. His brokerage trade history will show this as a buy of 1,000 shares at $50 each for a total cost of $50,000.

But according to the IRS rules, when preparing his taxes, Joe needs to reduce the cost basis of the 1,000 shares by the amount he received from selling the put.

$50,000 - $4,900.00 = $45,100.00 (Joe's adjusted cost basis for the 1,000 shares)

But like I said, nothing in the real world is easy. What happens if the ten contracts do not all get exercised at the same time?

What if two contracts get exercised on day one, three on day two, four more later on day two, and one on day three resulting in his buying four different lots of ABC stock being purchased at $50 per share? How does the premium received from the puts get divided up among the various stock assignments?

You guessed it, Joe bought 200 shares on day one at $50 for a total of $10,000 but he needs to reduce his cost basis by 20% (2/10) of the $4900 premium received from the puts. So his net cost basis for these 200 shares would amount to $9,120 ($10,000 - $980.00) commissions not included.

The same goes for the three other purchases of 300, 400, and 100 shares each with the remaining option premium divided accordingly.

In addition, the option trade needs to be zeroed out because the amount received from the option sale has been accounted for when reducing the stock cost basis.

Brokerages Offer Little Help

Now you would think all of this required accounting would be taken care of by your stock brokerage. Hardly. Prior to 2014 tax year, most brokers simply report the individual option sale and stock purchase transactions and leave the rest to you. Some brokers attempt to identify the exercised options and the corresponding stock assignments, but leave much to be desired in the way they do so.

TradeLog Software to the Rescue:

This is an extremely difficult, if not impossible problem to overcome with any automated trade accounting and tax software program. Few, if any, tax software programs designed for traders or investors handle this without much fuss and manual adjusting.

Thankfully, TradeLog is able to make all such necessary adjustments with just a few clicks of your mouse!

Exchange Traded / Broad-Based Index Options

If you trade exchange traded index options (ETF/ETN options), or other non-equity options such as on bonds, commodities, or currencies, the results of a sale are treated differently.

For example, options on the SPX, OEX, and NDX are not directly or indirectly related to a specific equity (stock), but are exchange-traded options of index stocks. These are subject to the provisions of IRS Code Section 1256, which states that any gains or losses from the sale of these securities are subject to the 60/40 rule (60% of gains and losses are long-term and 40% are short-term, regardless of how long the securities are held). Non-equity options are usually reported on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles).

Please see our Broad-Based Index Options user guide page for a complete list of index options marked by TradeLog as section 1256 contracts. TradeLog also allows users to define additional securities as broad-based index options in the Global Options settings.

There have been many conflicting opinions as to whether QQQQ, DIA, and SPY options should be treated as section 1256 contracts or not. Since these do not settle in cash, as do most section 1256 contracts, some suggest that these are not section 1256 contracts. Others feel that they meet the definition of a "broad-based" index option and therefore can be treated as section 1256 contracts.

A recent article in Forbes magazine highlights just how complex the tax laws are when it come to Options and ETFs, and why you cannot rely on your broker 1099-B for proper tax treatment: Tax Treatment Can Be Tricky With Options and ETFs.

As always, it is best to contact your tax professional for advice before arbitrarily categorizing your index options trades.

TradeLog generates IRS-ready tax reporting for options traders.

Please note: This information is provided only as a general guide and is not to be taken as official IRS instructions. Cogenta Computing, Inc. does not make investment recommendations nor provide financial, tax or legal advice. You are solely responsible for your investment and tax reporting decisions. Please consult your tax advisor or accountant to discuss your specific situation.