Tax Treatment of Options

Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form Firstly, when call options are exercised, the premium is included as part of the cost basis of a stock. Put options receive a similar treatment: This applies even if the proceeds were taxed in a previous year, and no T1Adj was filed to reverse this. Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options. Section trades are exempt from Section wash sale rules and straddle loss deferral rules since no open positions are deferred at year-end.

A put option gives the “holder” (the option owner) the right to sell a specified publicly traded stock at a set price (”strike price”) on or before a specified date. A call option, on the other hand, gives the holder the right to buy a security at a set price.

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A trader can open an options trading account with just a few thousand dollars vs. When it comes to option taxation, complex trades with offsetting positions raise complex tax treatment issues like wash sale and straddle loss deferral rules. Investors also trade options to manage risk in their investment portfolios. For example, if an investor owns significant equity in Apple and Exxon, he or she may want to trade options to manage risk or enhance income on long equity positions. Traders also use ETFs and indexes for portfolio-wide insurance.

Investopedia has explanations for different option trading strategies. Tax treatment for outright option trades is fairly straightforward and covered below. Tax treatment for complex trades triggers a bevy of complex IRS rules geared toward preventing taxpayers from tax avoidance schemes: Options on commodity ETFs structured as publicly traded partnerships are non-equity options taxed as Section contracts.

Options on futures are taxed as futures, which are Section contracts. Capital gains and losses for securities are reported when realized sold or closed. MTM imputes sales on open positions at market prices so there is no chance to defer an offsetting position at year-end. Complex trades lead to complex tax treatment issues In general, if an investor has an offsetting position he or she should look into more complex tax treatment issues.

In the old days, shrewd professional options traders would enter offsetting positions and close out the losing side before year-end for a significant tax loss and let the winning side remain open until the subsequent year. They used this strategy to avoid paying taxes. The IRS goes through and causes great pains to prevent this type of tax avoidance. Unused losses are treated as sustained in the next tax year. IRS enforcement of offsetting position rules Frankly, the offsetting position rules are complex, nuanced and inconsistently applied.

There are insufficient tools and programs for complying with straddle loss deferral rules. Few local tax preparers and CPAs understand these rules, let alone know how to spot them on client trading records. The IRS probably enforces wash sale and straddle loss deferral rules during audits of large taxpayers who are obviously avoiding taxes with offsetting positions.

Wash sales As we stress in our extensive content on wash sale loss deferral rules, Section rules for taxpayers require wash sale loss treatment on substantially identical positions across all accounts including IRAs. Substantially identical positions include Apple equity, Apply options and Apple options at different expiration dates on both puts and calls. If a taxpayer re-enters a substantially identical position within 30 days before or after existing a position, the IRS defers the tax loss by adding it to the cost basis of the replacement position.

When a taxable account has a wash sale caused by a replacement position purchased in an IRA, the wash sale loss is permanently lost. Brokers report wash sales based on identical positions , not substantially identical positions. Investors who trade equities and equity options cannot solely rely on Form Bs and they should use their own trade accounting software to generate Form Learn more about wash sales in our Trader Tax Center. Straddle loss deferral rules Options traders use option spreads containing offsetting positions to limit risk and provide a reasonable opportunity to make a net profit on the trade.

Why would an options trader do that? For tax avoidance reasons only. The IRS straddle loss deferral rules are set up to catch this trader and prevent this type of tax avoidance. The straddle loss deferral rule defers a loss to the subsequent tax year when the winning side of the position is closed, thereby reversing what the unscrupulous trader was trying to achieve.

Transaction-related expenses carrying costs and margin interest certain interest are also deferred by adding them to the cost-basis of the offsetting winning position. Learn more about straddle loss deferral rules in connection with options in IRS Pub. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period.

Tax treatments for in-the-money ITM covered calls are vastly more intricate. When writing ITM covered calls, the investor must first determine if the call is qualified or unqualified , as the latter of the two can have negative tax consequences. If a call is deemed to be unqualified, it will be taxed at the short-term rate, even if the underlying shares have been held for over a year.

Protective puts are a little more straightforward, though barely just. If an investor has held shares of a stock for more than a year, and wants to protect their position with a protective put, he or she will still be qualified for long-term capital gains.

The wash sale rule applies to call options as well. For example, if Beth takes a loss on a stock, and buys the call option of that very same stock within thirty days, she will not be able to claim the loss. Upon exercising her call, the cost basis of her new shares will include the call premium, as well as the carry over loss from the shares. The holding period of these new shares will begin upon the call exercise date.

Similarly, if Beth were to take a loss on an option call or put and buy a similar option of the same stock, the loss from the first option would be disallowed, and the loss would be added to the premium of the second option. Finally, we conclude with the tax treatment of straddles.

Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. Taxes on options are incredibly complex, but it is imperative that investors build a strong familiarity with the rules governing these derivative instruments.

This article is by no means a thorough presentation of the nuisances governing option tax treatments and should only serve as a prompt for further research. For an exhaustive list of tax nuisances, please seek a tax professional. Exercising Options Firstly, when call options are exercised, the premium is included as part of the cost basis of a stock. Pure Options Plays Both long and short options for the purposes of pure options positions receive similar tax treatments.

Below is an example that covers some basic scenarios: Covered Calls and Protective Puts Covered calls are slightly more complex than simply going long or short a call, and can fall under one of three scenarios for at or out-of-the-money calls:

May 27, 2015 | By: Robert A. Green, CPA

May 29,  · Options trading is proliferating with the advent and innovation of retail option trading platforms, brokerage firms and trading schools. A trader can open an options trading account with just a few thousand dollars vs. $25, required for “pattern day trading” equities (Reg T margin rules). Jan 31,  · Nonstatutory Stock Options. If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined. This constructive sale rule applies when offsetting long and short positions are entered in the same security. For example, if you buy shares of stock and later sell short shares of the same stock, it could be treated as a constructive sale. The same rules could be applied when options are used to .