Taxes on options

This material is lightly tested, but we’ve included it for completeness.

You learned several options strategies in the options unit. In this chapter, we’ll discuss the various tax consequences of options. The topics covered require a baseline knowledge of options; click the link above to review the various tested strategies. In general, you’ll need to know the tax consequences relating to five topics:

• Expiration
• Trading (closing out)
• Exercise
• Put hedges
• Holding periods

Expiration

When an investor buys or sells an option, there are three potential outcomes:

• Expiration
• Trading the contract (closing out)
• Exercise

We’ll discuss the expiration of options contracts in this section. When an options contract expires, the result is a capital gain or loss equal to the premium. It’s as simple as that! Let’s take a look at an 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?

Let’s try 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?

Trading (closing out)

Before an exercise or expiration, an options investor can trade (close out) of the position. From a tax perspective, investors realize capital gains or losses equal to a contract’s overall gain or loss. Let’s take a look at an 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?

One more example:

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?

Exercise

Taxes related to exercising contracts are more complicated than expiration or trading. Instead of a capital gain or loss, an exercise establishes cost basis or sales proceeds on the underlying security (typically stock). Cost basis represents the overall cost to purchase a security, while sales proceeds represents the overall liquidation value to sell a security. Let’s go through an example together:

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?

The investor buys 100 BCD shares at $25 when the call is exercised. Because they’re buying stock, the investor establishes cost basis. If they sold stock instead, the investor would establish sales proceeds. Determining if it’s cost basis or sales proceeds has nothing to do with buying or selling the option - it’s all about the action taken with the stock at exercise!

A $25 cost basis is the starting point. The option premium also needs to be factored in. Because the investor bought the option as well, we add the premium to the cost basis. The cost basis reflects the total cost of obtaining a security. In this scenario, the investor bought the option for $3 and the stock for $25, leading to an overall cost basis of $28 (per share).

A way to double-check your answer is to find the option’s breakeven. The cost basis (or sales proceeds) will always equal the option’s breakeven. You can find the call’s breakeven by adding the strike price ($25) to the premium ($3), which adds up to $28. This is a trick you can use to answer exercise-based tax questions.

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Let’s see if you can make it through three more examples on your own:

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?

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Let’s look at some put contract 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?

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One last example involving put contracts:

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?

This video summarizes the option taxation concepts we’ve discussed so far:

Put hedges

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.

Scenario #1

If an investor buys the stock and the put on the same day, the position is known as a married put. The reason for the name relates to how the position is viewed for tax purposes - it’s like the two positions come together as one. The option premium is added to the cost basis of the stock, and it’s like the option doesn’t exist (for tax purposes). 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 cost basis of the stock is $174, which is equal to the purchase price of the stock ($170) combined with the put premium ($4). Even if the put expires, there is no capital loss reported for the option (unlike other circumstances involving an option expiration). The $4 premium is reflected in the stock’s cost basis, which reduces tax liabilities when the stock is sold (a higher cost basis results in lower gains). Married puts do not affect the stock’s holding period. If the stock is held for over a year, the sale will lock in a long-term capital gain or loss. If held for a year or less, a short-term capital gain or loss occurs.

Scenario #2

If the put is bought on any other day 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 (they’re kept separate). The IRS institutes this rule to prevent investors from taking advantage of holding period rules. Let’s explore a scenario:

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.

The IRS assumes investors are attempting to “extend” their holding period to a long-term gain without risk exposure. Think about it - even if the market price falls, the investor can exercise the put and sell the stock at $190. Being a month away from locking in a long-term gain, are they at risk of losing anything? Not really.

For this reason, the IRS nullifies and resets the investor’s holding period to zero until the put is closed out or expires. Essentially, the investor has no holding period until the put is gone. If the put is closed out or expires, the holding period starts again from zero.

Scenario #3

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.

Thirteen months into owning the stock, the stock’s holding period is already long-term. In this scenario, the holding period is unaffected.

Holding periods

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, closes the position or allows it to expire, a long-term gain or loss is realized.

While this is true for long LEAPS contracts, 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 goes short LEAPS for three years, a short-term gain or loss is realized when the contract is closed out or expires. The belief is short securities are never truly “held,” which always leads to a short-term holding period.

Key points

Option expiration tax consequence

• Capital gain or loss equal to the premium

Option trading tax consequence

• Capital gain or loss equal to the overall gain or loss

Option exercise tax consequence

• Establishes cost basis if shares purchased
• Establishes sales proceeds if shares are sold
• Premium must also be factored

Married puts

• Long stock and long put on same day
• Put’s premium is added to stock’s cost basis
• Does not affect the holding period

Non-married puts

• Long stock and long put on separate days
• Put’s premium is not added to the cost basis of stock
• Holding period nullified and reset to zero if shares held short-term
• Holding period stuck at zero until put expires or is closed

LEAPS

• Long-term equity anticipation securities
• Options with expirations of up to 39 months

Option holding periods

• Capital gains and losses are generally short-term
• Long LEAPS may be long-term if held for longer than one year
• Short LEAPS are always short-term
• Short securities are ineligible for long-term status