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 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 get exercised all 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 no help
Now you would think all of this required accounting would be taken care of by your stock brokerage. Hardly. 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.
Now consider tax handling of broad based index options.
Please note: This information is provided only as a general guide and is not to be taken as official IRS instructions. Armen Computing Ltd. 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.