You learned several options strategies in the options unit.
This chapter covers the tax consequences of options. The topics here assume you already know the basic option strategies, so use the link above if you need a quick review.
In general, you’ll need to know the tax consequences relating to five topics:
When an investor buys or sells an option, there are three potential outcomes:
Here, we’ll focus on expiration. When an options contract expires, the tax result is a capital gain or loss equal to the premium. In other words, the entire premium is the gain or loss.
Example:
An investor goes long 1 ABC Jan 50 call at $4 when ABC’s market price is $51. Several months later, the ABC’s market price falls to $49 and stays there until expiration. What is the tax consequence?
Can you figure it out?
Answer = $400 capital loss
The investor bought a call, and it expires out of the money (no intrinsic value). Calls expire worthless if the market price is below the strike price at expiration. The investor paid $400 for the option and receives nothing at expiration, so they realize a $400 capital loss.
Another example:
One August 80 put is written for a premium of $7 when the underlying stock’s market price is $78. Just prior to expiration, the stock’s market price rises to $90. What is the tax consequence?
Answer = $700 capital gain
The writer sold a put, and it expires out of the money (no intrinsic value). Puts expire worthless if the stock’s market price is above the strike price at expiration. The investor keeps the $700 premium and is not assigned, so they realize a $700 capital gain.
Before exercise or expiration, an options investor can trade out of the position (close it). From a tax perspective, the investor realizes a capital gain or loss equal to the contract’s overall gain or loss.
Example:
An investor goes long 1 XYZ Dec 35 put at $5 when XYZ’s market price is $36. XYZ’s market price falls to $32, and the investor closes the contract at intrinsic value. What is the tax consequence?
Answer = $200 capital loss
To find the gain or loss, compare what the investor paid to open the position to what they receive when they close it.
Buying for $500 and later selling for $300 produces a $200 capital loss.
One more:
A client of yours writes 1 ZZZ Sep 60 call for a premium of $4. A few months later, the investor closes the position at $3. What is the tax consequence?
Answer = $100 capital gain
The client initially sold (wrote) the contract for $400. To close a short option position, the client must buy the contract back, which costs $300. The difference is a $100 capital gain.
Taxes related to exercising contracts are more complicated than expiration or trading. Instead of creating an immediate capital gain or loss on the option, exercise adjusts the tax numbers on the underlying security (typically stock).
At exercise, the key question is: are shares being bought or sold?
Example:
An investor goes long 1 BCD Apr 25 call at $3. BCD’s market price rises to $30, and the investor exercises the option. What is the tax consequence?
When the call is exercised, the investor buys 100 BCD shares at $25. Because shares are being purchased, exercise establishes cost basis.
Start with the strike price ($25). Then incorporate the option premium. Since the investor paid the premium to buy the call, the premium is added to cost basis.
A quick way to check: the cost basis (or sales proceeds) at exercise will equal the option’s breakeven. For a call, breakeven is strike price + premium ($25 + $3 = $28).
Now try three more examples:
A CDE Sep 75 call is written for $6 when CDE’s market price is $74. CDE’s stock price rises to $79, and the option is assigned. What is the tax consequence for the writer?
Answer = $81 sales proceeds (per share)
When a short (written) call is assigned, the writer must sell 100 shares at the strike price ($75). Because shares are being sold, exercise establishes sales proceeds.
Start with the strike price ($75). Since the writer received the premium, the premium is added to sales proceeds.
Put examples:
An investor goes long 100 shares of PEP stock at $120. A few months later, they go long 1 PEP Feb 120 put at $9 when PEP’s market price is $115. A few weeks later, PEP’s market price falls to $105, and the investor exercises the option. What is the tax consequence for both the stock and option?
Answers:
This question combines stock and an option.
When the long put is exercised, the investor sells the shares at the strike price ($120). Because shares are being sold, exercise establishes sales proceeds.
Start with the strike price ($120). Since the investor paid the premium to buy the put, the premium is subtracted from sales proceeds.
Overall tax consequence:
One last put example:
An investor writes 1 CBA Jun 150 put at $12 when CBA’s market price is $145. CBA’s market price falls slightly to $143, and the option is assigned. What is the tax consequence?
Answer = $138 cost basis (per share)
When a short put is assigned, the writer must buy 100 shares at the strike price ($150). Because shares are being purchased, exercise establishes cost basis.
Start with the strike price ($150). Since the investor received the premium for writing the put, the premium is subtracted from cost basis.
This video summarizes the option taxation concepts we’ve discussed so far:
We discussed how long puts protect long stock positions in the hedging strategies chapter. A long put can affect a stock’s holding period (long-term or short-term). There are three potential scenarios when an investor owns stock and purchases a protective put.
If an investor buys the stock and the put on the same day, the position is known as a married put. The name reflects how the IRS treats the position for tax purposes: the stock and put are treated as a single combined position.
For example:
An investor purchases 100 shares of WMT stock at $170 per share and goes long 1 WMT 165 put at $4 on the same day.
The stock’s cost basis becomes $174 per share ($170 + $4). Even if the put expires, there is no separate capital loss reported for the option. Instead, the $4 premium is already built into the stock’s cost basis, which reduces taxable gains (a higher cost basis produces a lower gain when the stock is sold).
Married puts do not affect the stock’s holding period:
If the put is bought on any day other than the day the stock is purchased, it can affect the holding period. Also, the put’s premium is not added to the stock’s cost basis (the stock and option are tracked separately).
The IRS uses this rule to prevent investors from using protective puts to reduce risk while still qualifying for long-term holding period treatment.
Example:
An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 eleven months later, and the investor goes long 1 WMT 190 put at $6.
At this point, the investor is close to long-term status. With the protective put in place, the investor can exercise and sell at $190 even if the market price drops, which limits downside risk.
For this reason, the IRS nullifies and resets the investor’s holding period to zero until the put is closed out or expires. Practically, the stock has no holding period while the put is open.
One exception to the rule discussed above is if the shares were already long-term. For example:
An investor purchases 100 shares of WMT stock at $170 per share. WMT’s stock price goes to $192 thirteen months later, and the investor goes long 1 WMT 190 put at $6.
Because the stock is already long-term after thirteen months, the holding period is unaffected.
When an options contract is traded or expires, the reported gain or loss is almost always short-term. Standard contracts maintain a maximum expiration of 9 months. A security held for a year or less is considered short-term and is subject to higher tax rates.
However, Long Term Equity Anticipation Securities (LEAPS) contracts maintain expirations of up to 39 months. If an investor buys a LEAPS option, holds it for over a year, then closes the position or allows it to expire, a long-term gain or loss is realized.
This long-term treatment applies to long LEAPS contracts, but it does not apply to short LEAPS. The IRS does not consider any short security (including short stock) eligible for a long-term holding period. Even if an investor is short a LEAPS contract for three years, a short-term gain or loss is realized when the contract is closed out or expires. The idea is that short securities are not treated as being “held,” so they never qualify for long-term status.
Sign up for free to take 25 quiz questions on this topic