The holding period for short-term securities is one year or less.
Short-term gains are netted against short-term losses to determine net short-term gain or loss.
Assuming no long-term capital transactions, net short-term capital gains are taxed at the highest marginal tax rate and net short-term capital losses may be deducted from ordinary income up to a maximum of $3000 per year.
The holding period for long-term securities is more than one year.
Long-term gains are netted against long-term losses to determine net long-term gain or loss.
Assuming no short-term capital transactions, net long-term capital gains are taxed at a maximum tax rate of 15% through December 31, 2010 and net long-term capital losses may be deducted from ordinary income up to a maximum of $3000 per year. The rate increases to 20% after 2010.
First In First Out - FIFO Identification Method
Taxation of Trading “Strategies”
Individual Retirement Accounts
Brokerage Statements & Form 1099-B
Options are included in the definition of a “security” under Sec 2(a)(1) of the Securities Act of 1933 which includes “any note, stock ... put, call, straddle [or] option ...”
Securities (stocks and options) are capital assets in the hands of investors. As such, they are subject to the rules for taxation of capital assets.
Capital assets are actually defined in Sec 1221 of the Internal Revenue Code by what they are not, ie, inventory, depreciable and real property (with exceptions) and others.
The gain or loss on the sale of a security is the difference between the gross proceeds on the sale of the security less its adjusted cost basis. Gross proceeds represents the number of shares or contracts sold multiplied by the price at the time of sale less commissions and fees - regulatory or SEC. Adjusted cost basis of stocks and options is the number of shares or contracts purchased multiplied by the price paid plus commissions and fees.
Capital gains and losses are further segregated by holding period, either long-term or short-term. One’s holding period for a stock or option traded on a securities exchange begins on the day following the trade date and ends on the day of disposition, again, the trade date. Settlement date is ignored for purposes of holding period determination.
Net capital gain or loss
Net short-term capital gain or loss is netted against net long-term capital gain or loss to determine net capital gain or loss.
There are various tax rate scenarios based on the amount of gain or loss for each holding period. The easiest way to evaluate each scenario is to study this handy Capital gain-loss scenario summary.
Not included in the summary is the scenario where an investor has a net long-term capital gain and is in the 10% or 15% marginal tax bracket. In that scenario, the capital gains are taxed at 0% or 5%, respectively. The 0% rate disappears after 2010.
For those investors/traders trading inside of a flow-through entity, the holding period and capital gain or loss is determined at the entity level. This information is provided to the entity owner typically on a Form K-1 for an S Corporation, partnership, limited liability company or trust. More is discussed on this topic in the Entities section.
When stock or options are acquired at different times and less than your entire holdings are sold, it is necessary to identify which shares or contracts were sold first. This determination has obvious tax ramifications in that it determines one’s holding period and the amount of taxable capital gain or loss.
Two methods are used to determine which securities are sold: (1) the first-in, first-out (FIFO) method or (2) the specific identification method.
If the securities cannot be or are not specifically identified, then the FIFO method is required ... the first shares or contracts purchased are the first sold.
If the specific securities can and are identified, then those are the ones deemed sold. The broker is required to acknowledge the identification of the securities in writing within a reasonable period of time. However, the Tax Court has ruled that other methods of specific identification are acceptable.
In the world of the online brokers and rapid-fire trading, specific identification is somewhat impractical. Therefore, FIFO is the typical method of identifying shares or contracts when less than one’s entire holdings are sold.
The loss from the sale or disposition of stock or options is not deductible if, within a period beginning 30 days before or 30 days after the sale that generated the loss (a 61 day window), the investor acquires substantially identical shares or contracts or acquires a contract or option to buy substantially identical stock. (IRS Publication 550, page 56)
Wash sales ONLY apply to losses. Therefore, if there is a gain on the disposition of stock or options, by definition there is no wash sale.
Basis - the basis of the newly acquired stock or option that triggered the wash sale is INCREASED by the disallowed loss.
Holding period - the holding period begins for the new stock or options on the same day as the securities sold.
These are complicated calculations which are exacerbated when options are exercised or assigned during the course of a trade.
An extensive wash sale example is provided here.
Even though trading securities generates capital gains or losses, because securities are typically capital assets, this is not the case inside an IRA.
When distributions are made from the IRA, those distributions are taxes as ordinary income even though the income inside the IRA was generated via the trading of capital assets.
A disturbing nuance to the interaction of tax-deferred IRA’s and taxable brokerage accounts deals with the wash sale rule described above. The wash sale rule, as stated in IRS Publication 550, can be triggered by the repurchase of securities within the 61 day window if that repurchase is made inside an IRA. In other words, a taxpayer’s IRA is a related party to the taxpayer for wash sale determination purposes.
There is little guidance on how this aspect of wash sales is actually implemented. Taxpayers and tax return preparers would need to merge the cash/margin account being reported on Sch D with the qualified account (IRA/SEP, etc) to determine if a wash sale existed.
Many option traders gravitate toward or become devotees of a particular type of trading strategies. For example, there are some methodologies that teach teach and advocate basic covered calls or short covered strangles. Others will venture into winged and iron-winged spread trades. There are many strategies to choose from and all can be profitable.
However, when it comes to reporting the trades on one’s tax return, each individual security is taxed, not a trade “strategy.”
As a quick example, let’s examine a one month covered call trade on General Electric before we delve into a more involved trade.
1. 1000 shares of GE is purchased on 8/3/2009 at $13.50 per share.
2. 10 Sep 2009 15 strike calls are sold for $0.75 per contract.
3. On the Sep expiration date (9/18/2009) GE closes at $16.50 and the shares are exercised.
Transaction 1: The Sep 09 15 short call generated $750 in premium and was held to expiration and was not repurchased - a short-term capital gain ($0.75 10 contracts 100 shares/contract)
Transaction 2: GE was sold for $15.00 (the short call strike) and generated a short-term gain $1.50 ($15.00 - $13.50 cost basis).
The Schedule D/D-1 will reflect the sale and expiration of the call and the purchase and sale of the stock - two line items.
Video illustrating the taxable transactions for a put calendar on the SPY
Video illustrating the taxable transactions for a covered call/collar on Amedisys
Here are two videos illustrating the taxable transactions embedded in trading strategies:
Brokerage statements, especially December statements, provide a valuable resource for preparing Sch D/D-1. However, be aware, they may not comply with IRS rules when calculating gains and losses.
Brokerage statements will provide a starting point for your evaluation of your profits and/or losses from investing/trading. If you have switched brokerages during the year and your new broker simply performed an ACAT transfer from your old broker, it will be your responsibility to determine your cost basis and holding period.
Beginning with tax year 2011, brokers will be required to report cost basis to the IRS along with sales (proceeds) of stock and option transactions. That has “disaster” written all over it ...
One of the most important sections of the brokerage statement is the open positions section, which should detail the open stock and option positions along with the number of shares and contracts open as of December 31. Again, you may need to use alternate records to determine cost basis and holding period. Another feature of this open positions section is that it typically provides the market value of the open positions, which is helpful for mark-to-market calculations.
Most online brokers provide customers the ability to download transactions into Excel®. This is a valuable activity and should be used frequently. You can create an electronic history of your trades so that you will have all the information necessary to create an accurate trade history for IRS reporting purposes. Plus, it allows you to sort and group your trading history by stock and/or option so that you can become a better trader!
The new Options Symbology Initiative may create a temporary consistency issue for “trades in progress” but should simplify the connection between options and the underlying stock.
One important point to remember is that you will need to make sure that the total gross proceeds on your Schedule D is greater than or equal to the sum of all your Form 1099-B Box 2 amount, otherwise you will hear from the IRS within 6-18 months.
One last thing. Option sales are NOT currently reported to the IRS so it is up to you to report your sales correctly.
Stock and option transactions are not typically taxed until the transaction is complete. An exception to this would be mark-to-market treatment.
Thus, for example, if you own GE stock and sell a call option in December that expires in January, you realize income in the form of the premium received for the sale of the call in December. However, the transaction is not complete until January so that December income is not taxed until the following year. Why? At year-end, there is no cost basis in the transaction. That January option may expire worthless or GE may begin to trend upward in which case you may decide to roll your short call up and out, thus creating basis for your January option.
In light of the aforementioned brokerage statements, an obvious problem exists. Those December option sales will be listed on the brokerage statement and probably on the detail comprising the Form 1099-B or Consolidated Form 1099. Option sales are NOT reported to the IRS for now, but will be shortly, which will present a problem when agreeing the options sales to the Form 1099.
But for now, when you reconcile your option sales provided on your Form 1099-B to your Sch D/D-1, you will have to subtract December option sales not recognized and add prior year December sales that will be recognized in the current year.
When a put is sold, premium is received just like when a call is sold. However, a short (sold) put creates an obligation for the writer/seller to buy the underlying stock if the price falls below the strike price. When that occurs, the process is called assignment.
So, when a put is assigned, stock is purchased at the strike price. But, the cost basis of that stock includes the premium received on the original sale of the put and therefore decreases the cost basis.
The same is true for call assignment. When a call is purchased and the underlying stock closes above the strike price at expiration, the stock is then purchased by (assigned to) the holder of the call. The purchase price of the call increases the basis in the stock purchased via the assignment process.
Beginning in 2011 for stock and 2013 for options, brokerages will be required to report basis to IRS.
This represents one more reconciliation challenge when comparing your Sch D/D-1 to what is reported on Form 1099-B and your option sales.
An Overview of Options Taxation
Index (Non-Equity) Options
Note: Most software packages for reporting the taxation of option trades DO NOT apply these rules. They are rules prescribed by IRS (Pub 550) that may actually benefit the taxpayer. Click here for a table describing tax requirements for Put and Call holders and writers.