Historically, options contracts have been a niche market occupied by professional investors. All that changed in recent years with the rise of no-fee online brokers. Now, retail investors trade options contracts regularly, and this means paying taxes on those trades.
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When you trade options the IRS generally applies capital gains tax rates. You typically report profits as either long-term or short-term gains based on how long you held the position. Here’s how it works.
Types of Options Contracts
While stock options are part of many people’s compensation packages at work, we’ll be focusing solely on options contracts for investors. There are generally two broad categories of investor options: equity and non-equity. Equity contracts are options that involve stocks and exchange-traded funds (ETFs). Non-equity contracts involve everything else.
The most common non-equity contracts involve commodities, meaning that you will trade futures contracts for products such as iron, coffee, lumber or any other physical material. That said, investors can trade non-equity options for literally anything, including asset portfolios like index funds and mutual funds. This can seem confusing, but the rule of thumb is as follows: If you can trade the asset on a stock exchange, it is an equity option. If you cannot trade the asset on a stock exchange, it is a non-equity option.
Taxation of Non-Equity Options
Non-equity options are also known as Section 1256 options, for the section of the tax code that covers them. Taxation here is relatively straightforward. The IRS applies what is known as the 60/40 rule to all non-equity options, meaning that all gains and losses are treated as:
- Long-Term: 60% of the trade is taxed as a long-term capital gain or loss
- Short-Term: 40% of the trade is taxed as a short-term capital gain or loss
This means that it doesn’t matter how long you hold the contract or underlying assets. Your tax status is always set at a 60/40 split.
If you hold a non-equity contract past the end of the calendar year (Dec. 31) you are required to declare an unrealized tax event for that contract as though you had sold it for its present value as of that day. As Section 1256 puts it, the contract “shall be treated as sold for its fair market value on the last business day of such taxable year (and any gain or loss shall be taken into account for the taxable year).” This resets the contract’s cost basis to the level of that unrealized gain going forward.
Taxation of Equity Options
Your tax liability for equity options depends on three issues: How long you held the contract, whether you bought (long position) or sold (short position) the contract and whether the contract was a cash or physical settlement.
Physical Settlement and Puts
The IRS does not tax equity options until you sell the underlying stocks. For cash-settlement contracts, meaning you only resolve the cash value of the contract without stocks changing hands, this rule doesn’t come up. Your tax status is determined by how long you held the option contract.
If you resolve a call contract with a physical settlement, meaning you receive the stocks themselves, the IRS determines your long- vs. short-term capital gains position based on how long you hold the stocks. If you exercise your contract and hold the stocks for less than 12 months, you will pay short-term capital gains. If you hold the stocks for more than 12 months, you will pay long-term capital gains.
This is also true for put contracts. If you resolve a put contract with stocks that you already owned, the IRS determines your long- vs. short-term capital gains position based on how long you owned the stocks. If you resolve a put contract without owning the underlying stocks, the IRS calculates capital gains based on how much time elapsed between exercising your option and closing the position, which almost always happens quite quickly.
Long Options (Buying the Contract)
When you hold a long option, there are three tax outcomes to consider:
You Close the Contract
Closing your position in an options contract means that you sell the contract without exercising it. Your gains or losses will be determined based on the price you paid for the contract compared to the price you received for selling it. You will be taxed at the long-term capital gains rate if you held your position for one year or more and the short-term capital gains rate if you held your position for less than one year.
The Contract Expires
If you allow the contract to expire without exercising it, you can claim a capital loss. This is a long-term capital loss if you held your position for one year or longer and a short-term capital loss if you held your position for less than one year.
You Exercise The Contract
If you exercise an option, you claim a long- or short-term capital gain based on the holding period for your position.
For a cash resolution, this is determined by how long you held the option contract. For a physical resolution call contract or a covered put contract, this is determined by how long you held the underlying stocks.
The cost basis for an options contract includes both the cost of the underlying asset and the premium that you paid (along with commission and any other associated fees). For example, say you purchased the following contract:
- Contract Type: Call, physical resolution
- Asset: 100 shares of XYZ Corp.
- Strike Price: $50 per share
- Purchase Date: March 1
- Expiration Date: June 1
- Premium: $1 Per Share
You exercise your contract on June 1 and take possession of the stocks. Then, 11 months later, you sell them for $55 per share. This would give you the following capital gain:
- Cost Basis Per Stock: $50 (the strike price) + $1 (the per-stock premium) = $51
- Contract Cost Basis: $51 x 100 (the number of shares) = $5,100
- Contract Revenue: $55 (the stock’s current price) x 100 (the number of shares) = $5,500
- Taxable Capital Gains: $5,500 (the contract’s revenue) – $5,100 (the cost basis) = $400
You paid $5,000 to take possession of these shares plus another $100 in contract premiums. When you sell the stocks, you make $5,500, giving you $400 in total capital gains. You pay short-term capital gains taxes on this transaction since you held the shares for less than a year.
For a cash-basis contract, you would not need to calculate the per-share cost basis. Instead, you adjust your earnings by the premium that you paid. For example, say you resolve the contract above on a cash basis at $55 per share and receive $500. Adjusted for the $100 contract premium, this gives you a $400 capital gain. This would also be a short-term capital gain, since you held the position for just three months.
Put contracts work the same way. If this is a cash-basis, you simply adjust your earnings by your premiums and pay taxes based on how long you held the contract.
If you open a put contract with shares of stock you already own, you adjust the cost basis of your stock by the contract’s premium and fees. If you held those stocks for more than a year when you exercise your option, you pay long-term capital gains. If you held them for less than a year, you pay short-term capital gains.
Short Options (Writing the Contract)
A short option position is when you write the contract and sell it to a third party. When you write an option contract, there are three tax outcomes:
They Close The Contract
If the third-party buyer closes their position, you pay short-term capital gains or losses depending on the outcome.
The Contract Expires
If the contract expires worthless, you pay short-term capital gains taxes on the money you made from selling the contract.
They Exercise The Contract
If the buyer exercises their contract, your taxes will be determined by your holding period of the underlying asset.
If you wrote a call contract, meaning that you sell them shares of stock, your long- or short-term capital gains will be determined by how long you owned the stock. You determine your gains or losses based on how much you received in premiums, as well as the sale of stock minus the cost basis of the shares.
If you wrote a put contract, meaning you purchase shares of stock from the contract holder, you do not resolve your taxes until you ultimately sell those shares. If you hold them for more than a year, you pay long-term capital gains. If you hold them for less than a year, you pay short-term capital gains. In all cases, your cost basis for this stock is offset by the amount you received in contract premiums.
How your options contracts are taxed depends on the nature of the contract and how long you hold the related assets. In most cases, you pay capital gains taxes on a long- or short-term basis. The world of options trading, however, is complicated and complex. The IRS applies different rules for how equity and non-equity options are taxed so it’s vital to understand which type of options contracts you’re dealing with.
Tips for Taxes on Investments
- Should you trade options? What other asset classes should be in your portfolio? A financial advisor can help answer these important questions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Not every investment can be a winner. That’s why it’s important to use investment losses to offset a portion of your capital gains. This strategy is known as tax-loss harvesting and it can save you big during tax season.
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