The Tax Treatment of Options Trading

So you’ve started trading options. In the past year, you’ve bought some calls and puts and sold a few options, too. Now it’s tax time, and you don’t know where to begin.  

You’re not alone. As options trading steadily grows in popularity, more and more investors are curious about how to account for their trades when tax season rolls around.

The truth of the matter is that the tax rules that govern options trading are a bit more complicated than the rules that govern equities trading. And the Internal Revenue Service (IRS) has special rules that just apply to options trading. But the good news is that the tax rules that apply to options trading are commonsense, especially for investors who are familiar with paying taxes on their investments.  

First, let’s review how taxes work and discuss the type of tax that is levied on investors. Then we can review how taxes are levied on both buying options and selling options and consider how to account for options that expire before they are used. Last, we’ll discuss how the IRS taxes options on non-equities, including exchange-traded funds (ETFs), and futures.

A Brief Introduction to Taxes

Taxes are fees that federal, state, and local governments levy against individuals and organizations who have received money from an activity. Governments collect taxes on individual income, corporate earnings, property, and sales of goods and services, among other things. Although the U.S. tax code is complex and contains numerous loopholes and exclusions, you can be almost sure that any time you come into money, the government will expect its cut. As Benjamin Franklin famously quipped over 300 years ago, “in this world, nothing can be said to be certain, except death and taxes.”

The type of tax that applies to options trading is called the capital gains tax. Capital gains taxes, which are imposed by the federal government and most state governments, are levied on the difference between the amount an asset was sold for and the amount it was purchased for. Let’s say you bought one share of a stock for $25 in January. Later that year, in September, you sell the share for $40. A short-term capital gains tax would be levied on the $15 difference between the two amounts. Short-term capital gains taxes apply to assets that are bought and sold within 365 days or one year. Long-term capital gains taxes, on the other hand, refer to assets that are sold over a year after they were purchased.

Why does it matter if a capital gain is classified as short-term or long-term? For most investors, short-term capital gains tend to be taxed at a higher rate than long-term ones. In 2020, the tax rate for short-term capital gains topped off at 37%. The tax rates for long-term capital gains were 0%, 15%, and 20%. A general rule of thumb is that the more money you make, the higher your tax rate.

To maximize profit, it’s essential to keep in mind the rate at which you will be taxed and plan accordingly.

Tax Rules for Options Buyers

So far, we’ve discussed how capital gains applies to the sale of equities. How do capital gains taxes apply to options? Let’s keep it simple and explain the taxes that apply to options on equities first. We’ll get to taxes on non-equity options later.

First, remember that an option is a contract that gives a person the right, but not the obligation, to buy or sell a stock at a fixed price (called the strike price or exercise price) by a specific date (the expiration date or exercise date). There are two types of options: calls and puts. If an investor buys a call, they have the right to buy 100 shares of an equity at the strike price before the expiration date. If an investor buys a put, they have the right to sell 100 shares of an equity at the strike price before the expiration date. For the privilege of having a call or put option, the buyer pays the seller a fee, called the premium. (Want to learn more about getting started with options trading? Check out our article on the subject.)

There are a few outcomes when you buy an option: you either exercise the option (that is, you sell the option and close it out, exercise and buy shares of an equity at the strike price, or you let the option expire. What you choose to do with the option will affect you at tax time. You can always choose to buy or sell the option and close it out before expiration.

Here are the tax rules for buying calls:

  • If you exercise the call and buy the shares at the strike price, and later sell the shares at a higher price, your cost basis will be the sale price minus the cost of the call (the premium, as well as any transaction costs) plus the amount you paid for the shares. (The amount of time that you hold the call matters. If you own a call for over a year before you sell it, it is considered a long-term capital gain; if you keep it for less than a year, it’s regarded as a short-term capital gain.)
  • If you exercise the call and keep the shares, you will not be taxed, as capital gains taxes are only applied after shares are sold.
  • If you let the call expire without exercising it, then you will report the cost of the call (again, the cost is the premium plus any transaction costs) as a short-term or long-term capital loss.

Here are the tax rules for buying puts:

  • If you exercise the put and sell your shares at the strike price, then you will be taxed on the amount of the sale of the shares minus the cost of the option. (Whether you will be taxed at a short-term or a long-term rate depends upon how long you held the put.)
  • If you let the put expire without using it, then you will report the cost of the put as a short-term or long-term capital loss.

Tax Rules for Options Sellers

For every call and put purchased, there is a seller (also referred to as the writer) who has an entirely different strategy than the buyer. For example, while the buyer of a call hopes that an equity’s share price will rise, the seller of a call hopes for the opposite (or, at least, for the share price to remain roughly the same).

After the seller sells an option to a buyer, there are a few things that could happen: the buyer could close out the option the buyer will exercise the option, or they will let it expire. What the buyer does determines how the seller will be taxed.

Here are the tax rules for selling calls:

  • If the buyer of the call exercises the option, then you, the call seller, are obligated to sell the shares of the optioned stock. You will be taxed on the amount you received from the sale of the shares plus the premium the call buyer paid you. (How long you held the stock prior to selling the option will determine whether you pay long- or short-term capital gains.)
  • If the buyer of the call never exercises the option, then you, the call seller, will report the cost of the call as a short-term capital gain, regardless of how long you owned the stock.

Here are the tax rules for selling puts:

  • If the buyer of the put exercises the option, then you, the seller, are obligated to buy shares of the optioned stock. You will be taxed on the amount of the sale of the shares minus the premium the put buyer paid you whenever you ultimately decide to unload the shares. When you choose to sell the shares (within a year? after a year?), will determine your tax rate.
  • If the buyer of the put never exercises the option, then you, the seller, of the put must report the cost of the put as a short-term capital gain.

Tax Rules for Optioning Non-Equities:

So far, we’ve discussed the tax rules that apply to the optioning of equities. Equities are shares that confer the holder partial ownership in a company. Optioning non-equities, such as bonds, ETFs, futures, and commodities, is treated differently by the IRS.

According to IRS Code Section 1256, taxes on options trading of non-equities are subject to the 60/40 rule, which stipulates that 60% of capital gains are long-term and 40% are short-term, regardless of how long an option is held.

Key Takeaways for the Options Trader

In general, it’s a good idea to understand the tax rules that govern options before you begin trading. That way, when tax day rolls around, you’ll have zero surprises.

It’s also a good idea to keep taxes in mind when developing an options strategy. For example, holding on to an option for 366 days instead of 364 days may neatly reduce your tax burden. While lowering your tax bill shouldn’t be the primary goal of your options strategy, it should undoubtedly be a consideration.

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