The goal of our article is to introduce you to the basics of options trading taxes. But it’s crucial to note from the beginning that understanding and calculating options taxes in a real situation may be the most complex task for the options trader.
So, you should always hire a tax professional to avoid penalties or overpaying taxes.
Now that we’re clear, we can begin!
Options Trading Taxes
Before we start looking at how calls and puts are taxed and check out tax treatments related to options trading, we have to clarify some basic things.
Capital gain and income taxes on investments belong to the same frame regardless of whether you use options, stocks, or other financial instruments. However, they’re taxed differently. Speaking of that, even features, which are also classified as derivatives, are taxed differently than options.
So, we’ll start with the capital gains tax and talk about the special circumstances of options trading. We’ll see the differences and similarities between taxes to explain options better.
Capital gains tax
Capital gain is one of the income types that refers to gains coming from selling assets with a higher value than their initial purchase value.
Now, the thing that you have to understand is that capital gains taxes apply only after you sell your investment.
The capital gains are taxed depending on how long the assets have been held by the investor. Therefore, we have short-term and long-term capital gains tax.
Long-term and short-term capital gains tax
Capital gains are considered long-term if the asset you sold to gain capital was in your possession for more than one year.
In terms of taxes, long-term capital gains are better because they’re taxed at a more favorable rate. You should know that this tax treatment started after the passage of the Tax Cuts and Jobs Act in 2018. Until then, long-term gains had similar tax brackets to those for income tax.
These acts include unique tax brackets for long-term gains with numbers that usually change every year. The gains are subject to 0%, 15%, and 20% rates, depending on the income.
Short-term capital gains, on the other hand, are gains from selling assets that were in your possession for less than a year. However, the most important difference between long-term and short-term capital gains is that the latter are taxed as ordinary income.
So, just like ordinary income, short-term capital gains have seven tax brackets. They’re subject to 10%-37% tax rates.
How is this related to options?
The reason we briefly explained long-term and short-term capital gains tax is that, as an options trader, you’ll find these definitions when calculating your taxes. Besides, it’s crucial to understand them so that you can see the difference in how earnings are treated when they come from various financial instruments.
General experience so far has shown that beginner investors and traders often overlook taxes when making investment decisions.
Factors affecting options trading taxes
While we’ll go into more detail about tax treatment for calls and puts later, we want to give you an idea of how options are classified in terms of taxes. Generally speaking, most profits from options trading are considered short-term capital gains.
However, you wouldn’t need this article if things were that simple.
Multiple factors affect options trading taxes. For instance, there’s one tax treatment for exercising in-the-money options and another tax treatment for closing out a position for profit.
It’s crucial to note that your options trading strategy also affects the method you use to calculate the gain or loss. The same applies to the hold period. Thus, the strategy and the timeframe indirectly impact the tax treatment.
Let’s also not forget that tax treatments vary depending on whether you’re an options buyer or an options writer.
Options Trading Tax Treatment
In the following sections, we’ll cover various scenarios of calls and puts to see how they are taxed.
Long calls and puts
How long calls and puts can be taxed varies from contract to contract, that is, how the trade will end.
Closed before expiry
If you go long on a call and the position is closed before the expiration date, the holding period (the period through which you hold the option) is the tax decision-maker.
Based on the period through which you’ll hold the contract, the option may be taxed as a short-term or long-term capital gain.
The same applies to long puts.
Exercising calls and puts
The situation is different if you, as a buyer, exercise the option. If you decide to exercise a call, this means that the cost basis of the underlying will increase. Therefore, the gain can be taxable once you sell the underlying.
The period during which you hold the underlying (between purchase and sell) will determine whether the gain will be short or long-term.
Exercising puts has the opposite result. If you decide to exercise a put option, you’ll lower the amount you’ve realized from selling the underlying. The price reduction equals the premium you paid for the put option.
The option expires
Here we have the same situation as when the position is closed before expiration. When you purchase an options contract, the contract can be closed before expiry, exercised, or it can expire without being exercised.
When the option expires, the holding period is the decision maker about whether the capital gain or loss is long- or short-term. The same applies to put options.
Short calls and puts
Let’s check out tax treatments for short calls and puts.
Closed before expiry
Whether you write a call or a put and you buy the same contract to close, your loss is considered a short-term loss.
Exercising calls and puts
There are multiple possible scenarios if you write a call or put and the option gets exercised. The outcome depends on the option type.
If the option is a naked call, the shares will be called away when the contract gets exercised. So, the premium you received for the option is added to the selling price of the shares. As we’re talking about a naked call, this is considered a short-term transaction in terms of taxes.
When it comes to covered calls, the gains or losses can be taxed as both short- or long-term capital gains. This means that the tax treatment will depend on how long you have owned the underlying prior to writing the option.
Here’s another important thing to remember - you can write an ITM covered call. In this situation, whether you’ll qualify for short- or long-term capital gains will depend on whether the ITM covered call is qualified or unqualified.
If you write put options and they get exercised, you have to subtract the premium from the average share cost. Whether you qualify for short- or long-term gains will depend on how long the trade stays open.
The option expires
When the call or put options contract expires unexercised, your gain as an options writer is considered a short-term capital gain and taxed accordingly.
The straddle rule
Options straddle is a well-known options trading strategy. Traders use straddles, spreads, covered calls, butterflies, strangles, and many more strategies to gain profit.
However, when it comes to options trading taxes, the IRS (Internal Revenue Service) uses different terminology. Shortly, the IRS sets most of these strategies into one category and refers to them as a straddle.
In fact, every strategy in which you’ll take an opposite position in similar financial instruments in order to lower the risk of loss is considered a straddle by the IRS.
Here’s an example - in terms of options trading taxes, a straddle occurs when you own stock in a particular company, and you buy a put option to protect against downside movement. The IRS considers this as an action you took to limit your downside risk.
Let’s say you enter a straddle where you have a $7 capital loss on a call. Your put has an unrealized gain of $5, so you decide to sell back the call option. According to the IRS straddle rule, you can’t recognize a loss of $7 (the entire call option) because you have a $5 unrealized gain.
This means that according to this rule, you have to recognize a loss of $2 in your tax return.
Wash sale rule
Here’s another significant rule you have to consider - the wash sale rule is a tax rule by which taxpayers are prevented from deducting their losses on assets replaced within 30 days.
We’re all familiar with the wash sale “strategy,” and that’s why the IRS passed this rule. Since options are financial instruments, options traders also have to stick to this rule, which means they shouldn’t acquire security 30 days before or after selling similar security. If they do, the loss will be disallowed.
Conclusion
This is it! These are the basics of options trading taxes and some general rules that apply to options. As you have seen, tax regulations for options trading are more complex than treatments for other securities. That’s why hiring a tax professional is a must.
But, to pay taxes on capital gains, you first have to profit from trading options. Like with everything else, hiring professionals to assist you is always the right thing to do.
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