You learned several options strategies in the options unit. This chapter focuses on the tax consequences of options. The topics here assume you already know the basic strategies, so use the link above if you want a quick review.

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 possible outcomes:

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

This section focuses on expiration. When an options contract expires, the tax result is a capital gain or loss equal to the premium.

Let’s 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 exercise or expiration, an options investor can trade out of the position (close it out). This was covered in the issuance & the market chapter.

From a tax perspective, closing out produces a capital gain or loss equal to the contract’s overall gain or loss (what you paid versus what you received when you closed).

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:

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 exercise are more involved than expiration or trading. Exercise doesn’t create an immediate capital gain or loss on the option itself. Instead, it adjusts the tax numbers on the underlying security (typically stock) by establishing either:

• Cost basis: the total cost to purchase the shares
• Sales proceeds: the total amount received when selling the shares

The key point: whether you establish cost basis or sales proceeds depends on what happens to the stock at exercise (buying shares vs. selling shares), not on whether you originally bought or wrote the option.

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?

Exercising a long call means the investor buys 100 shares at the strike price ($25). Because the investor is buying stock, exercise establishes cost basis.

Start with the strike price ($25), then incorporate the premium:

• The investor paid $3 for the call.
• For a long call exercise, the premium is added to the stock’s cost basis.

So the cost basis is $25 + $3 = $28 per share.

A quick way to check yourself is to use breakeven. The cost basis (or sales proceeds) created by exercise will equal the option’s breakeven. For a call, breakeven is strike price + premium: $25 + $3 = $28.

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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?

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Now for 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?

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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?

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. For tax purposes, the stock and put are treated as a single combined position.

• The put premium is added to the stock’s cost basis.
• The option is essentially ignored for separate tax reporting.

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 on the option. Instead, the $4 premium remains embedded in 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 stock is held for over a year, the sale produces a long-term capital gain or loss.
• If the stock is held for a year or less, the sale produces a short-term capital gain or loss.

Scenario #2

If the put is bought on a different day than the stock purchase, it can affect the holding period. In this case:

• The put premium is not added to the stock’s cost basis.
• The stock and option are treated separately.

The IRS applies this rule to prevent investors from using protective puts to qualify for long-term treatment while taking on little or no downside risk.

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.

Because the investor can exercise the put and sell at $190 even if the market falls, the IRS treats the holding period as suspended.

For this reason, the IRS nullifies and resets the investor’s holding period to zero until the put is closed out or expires. In other words, the investor has no holding period while the put is in place. Once the put is closed or expires, the holding period starts again from zero.

Scenario #3

One exception to the rule above applies 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.

Holding periods

When an options contract is traded or expires, the reported gain or loss is almost always short-term. Standard contracts have 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 have expirations of up to 39 months. If an investor buys a LEAPS option, holds it for over a year, and 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, but not to short LEAPS. The IRS does not treat any short security (including short stock) as eligible for a long-term holding period. Even if an investor is short a LEAPS contract for three years, the gain or loss is still short-term when the contract is closed out or expires. The idea is that short securities are not considered “held” in a way that qualifies for long-term status.