Assignment & Exercise
So what is the process of Assignment and Exercise?
There are a particular set of rules regarding assignment and exercise of options. Those rules are generally enforced by the Options Clearing Corporation (OCC).
Remember, with American style options, the holder of the option has the right to exercise that option at any time before the option expires.
What we are concerned with here is only the automatic exercise of option contracts because that process affects cost basis in the underlying stock. With automatic exercise, generally the OCC will automatically exercise any expiring equity option (call or put) if it is at least $0.01 in-the-money.
What does that mean?
Long: If you purchased (BTO) a call on Apple with a strike price of 150 that expires in August of 2017 and Apple closes on expiration Friday at $150.01 or higher, you will automatically be assigned shares of Apple based on the number of calls held. In other words, if you held 1 contract, you will now purchase 100 shares of Apple at $150 per share.
Short: If you sold (STO) a call on Apple with a strike price of 150 that expires in August of 2017 and Apple closes on expiration Friday at $150.01 or higher, you will automatically be forced to deliver 100 shares of Apple stock to the holder/buyer of that call option. If you do not already own the shares (a naked call position) you will have to purchase the shares at the market price when the market opens. If you already own the shares (a covered call position), 100 of your Apple shares will be delivered to the holder of the call option.
Long: If you purchased (BTO) a put on Apple with a strike price of 150 that expires in August of 2017 and Apple closes on expiration Friday at $149.99 or lower, you will automatically be short Apple shares based on the number of puts held. In other words, if you held 1 contract, you will be short 100 shares of Apple at $150 per share. You can now “cover” your position by purchasing 100 Apple shares in the market at presumably a price lower than $150. However, there is the obvious weekend risk associated with being short stock, which is beyond the scope of this discussion and subject to your broker’s rules.
Short: If you sold (STO) a put on Apple with a strike price of 150 that expires in August of 2017 and Apple closes on expiration Friday at $149.99 or lower, you will automatically be obligated to purchase 100 shares of Apple stock from the holder/buyer of that put option. This is called a naked put position and is a great way to get into a stock at a lower price, assuming you have the cash in your account to facilitate the purchase - a cash-secured naked put.
What are the tax implications of automatic assignment or exercise?
Contrary to some opinions, options CAN impact the cost basis of your underlying stock positions. So how can that happen if they are separate securities? Let’s look at some examples:
Example 1 - Assigned Puts:
In December 2016 American Airlines (AAL) is trading at $46 per share. You believe it could go higher but you don’t want to purchase the stock at the current price. You sell 10 Mar 2017 42.50 puts (naked, but cash secured) for $0.60 per contract and bring in $600 premium (ignoring commissions). At March expiration, AAL has dropped to $41.72 per share and you are assigned the stock for $42.50. Your basis in those shares is not the $42.50 purchase price but $41.90 ($42.50 strike price minus the $0.60 received from selling the put). Also, as described above, the premium for selling that put in December is not income in 2016 but decreases the cost basis in the stock purchased in March, which is also when the holding period begins.
What happens to the put originally sold? It is NOT reported on your tax return!! The underlying stock price “absorbs” the premium into its new cost basis.
Essentially, this treatment has the potential to turn what would have been a short-term capital gain into a long-term gain. If the assigned shares are held more than one year, the premium received from the sale of the put is now buried in the basis of the stock which is subject to long-term capital gain treatment - a result which I believe was unintended by Congress.
Example 2 - Exercised Calls:
In March 2017 McDonalds (MCD) is trading around $130. You believe it has the potential to go higher by the end of 2017 and buy to open (BTO) a call option on MCD with a strike price of 140 and an expiration in April 2017. On the April 2017 expiration date, MCD closes at $133.41 and you are assigned shares. The option originally cost $0.95 so your basis in MCD is now $130.95 per share ($130 strike price + $0.95 paid for the call option).
What happens to the call originally purchased? It is NOT reported on your tax return!! As in the previous example, your basis for gain or loss has been increased by the price paid for the call.
Download the following Table as an Adobe pdf by clicking here
Example 3 - Exercised Put
In October 2016 Allergan PLC (AGN) is trading around $235 but you believe it is overpriced. You purchase a put with a strike price of 200 for the November 2016 expiration cycle. AGN closes at $191.78 on expiration Friday and you are exercised. You are now short 100 shares of AGN which you sold for $200. Assume you paid $1.50 for the put and you buy to cover your short sale for $188 when the market opens the following Monday. Your basis for gain or loss is $188.00 ($188 buy to cover) and your net proceeds from the short sale are $198.50 ($200 strike - $1.50 cost of the put). Therefore, your gain is $10.50 per share ($198.50 less $188 basis) or a total of $1,050.
Example 4 - Assigned Call
In June 2017 you purchase Gilead Sciences (GILD) on a dip for $65 and then sell a September 2017 70 call for $1.25. The closing price on the September expiration day is $82.36 and your shares are assigned at $70 - you forego the gain from $70 to $82.36. Your basis for gain or loss is $65 and the proceeds from the sale are $71.25 ($70 strike price + $1.25 received for the call).
However, this treatment may not agree to the gross proceeds on Form 1099B. You will achieve the same result by reporting these two transactions separately. This treatment is illustrated, in part, with the video on the Apple covered call adjusted into a collar, which you can view here or on the section explaining how to report Trading Strategies.
Holding Period Adjustment
So, while we’re on the subject of Assignment and Exercise, when an underlying is either assigned or exercised, or in this case, you now own the stock or ETF, when does the holding period for that underlying begin?
Does it begin on the date the option is purchased or written (short)?
Does it begin on the day of the assignment/exercise?
The answer is actually neither. The holding period begins on the day AFTER the exercise/assignment. The holding period for the option ends on the day of assignment/exercise.
Therefore, you hold a short put that expires 7/19/2014. The underlying drops into the money (ITM) and you are assigned the shares. Since the expiration date of the option is technically on Saturday, the first day of the holding period for the underlying would be Sunday, 7/20/2014 - a non-business day in which the market is not open.
Conclusion: In the previous example, there are two securities with two distinct holding periods:
The option contract has a holding period beginning on the day the contract was entered into and ending on the Saturday following the third Friday (assuming a regular option), and
The underlying security whose holding period begins on the day AFTER the assignment or exercise.
Also, keep in mind that there could also be wash sale implications for various holding period scenarios.
Does This Really Matter?
Well, actually, it does and it doesn’t.
It Does - IRS Publication 550 explains how exercised and assigned shares should be reported as to proceeds and basis, as reflected above. However, not every brokerage firm complies with Pub 550, and you do not want to ignore IRS rules, at least not without a good reason - which translates to having substantial authority that is contrary to the rule.
It Doesn’t - Whether one reports the exercise of long options and assignment of short options according to the instructions contained in Pub 550 or not, the ultimate gain or loss is the same - the timing could be different.
So what should I do?
In my opinion it depends on the broker. If a taxpayer reports amounts which disagree with what a broker reports to IRS it must be explained in the ‘Adjustment’ column of Form 8949. So, if a trader is assigned shares via a short put and adjusts the basis of the underlying down by the proceeds received from the sale of the put and the broker does not report the basis decrease, an adjustment results. But, the broker would report the sale of the put and a buy to close at zero, resulting in a gain that exactly offsets the basis reduction. In this scenario, there is a possible detrimental impact on the taxpayer as explained above in Example 1 - a holding period adjustment.
Aren't Brokers Required to Adjust Basis and Proceeds?
Since the brokers have been required to adjust basis for put/call assignment and exercise since 2014, basis and proceed adjustment has not been as much of a problem as it was prior to 2014.
Where it becomes problematic is when there have been wash sale adjustments. Wash sales impact the cost basis of the substantially identical security purchased. Therefore, even though the adjusted proceeds - from the sale of a call - the cost basis may not agree with you records. Thus, there could be multiple adjustments necessary, including basis, proceeds and holding period.
Further, sometimes there are just errors ... which makes it incumbent upon the taxpayer to keep very accurate records pertaining to assignment, exercise and wash sales in order to file a true, complete and accurate tax return.