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Taxation Overview

The taxation of options can become very complicated very fast.  You’ve come to this site to learn some tips about making it more understandable.  Hopefully this page will accomplish that.

The following topics are essential to the understanding of securities taxation in general and options taxation in particular.

 

Click on some of the headings below to take you to more on that topic

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.

Capital Gains & Losses

Short-term

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.

Long-term

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 20% (subject to change) and net long-term capital losses may be deducted from ordinary income up to a maximum of $3000 per year.

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%, which was scheduled to disappear after 2012 but has been extended.

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.

 
Capital Gain Rate Summary

For the 33% through the 39.6% marginal rate, capital gains may also be subject to the 3.8% Net Investment Income Tax described below.  These rates are for the 2017 tax year.

 

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 be 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 (see Note).

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.

First-In First-Out - FIFO Identification

Note:  Some brokers allow investors to specifically identify shares online instead of in writing.

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)

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 or other qualified account.

When distributions are made from the IRA, those distributions are taxed 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 occurs 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.

 
Taxation of Trading "Strategies"

Many option traders gravitate toward a particular type of trading strategies.  For example, there are some methodologies that 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".  I have discussed this topic with many traders over the years who vehemently believe that somehow they should report their particular strategy on their tax return.  They are, what I like to call - wrong!!

As a quick example, let’s examine a long call calendar on Apple Corp before we delve into more involved trades.

  1. 10 Sep 2017 150 long calls on AAPL are purchased in April 2017 at $10 per contract.

  2. 10 Jun 2017 150 strike calls are sold for $3 per contract and expire worthless.

  3. Then, 10 Sep 2017 160 strike calls are sold for $2 per contract and expire worthless.

  4. On Sep expiration date AAPL is at $159 and the long calls are sold for $9

Transaction 1:  The Jun 17 150 short call generated $3000 in premium and was held to expiration and was not repurchased - a short-term capital gain ($3 x 10 contracts x 100 shares/contract)


Transaction 2:  The Sep 17 160 short call generated $2000 in premium and was held to expiration and was not repurchased - a short-term capital gain ($2 x 10 contracts x 100 shares/contract)

Transaction 3:  The Sep 17 150 long call was sold for $9000 generating a $1000 short-term capital loss [($9 - $10) x 10 contracts x 100 shares/contract]

The Form 8949 will reflect the sale and expiration of the two short calls and the sale of the long call - three line items, even though there was one "strategy" - a long call calendar.

 

Short video illustrating the taxable transactions for a Put Calendar on SPY

Short video illustrating the taxable transactions for a Covered call/Collar on AMED

Index (Non-Equity) Options

These types of options are also termed 1256 Contracts by the Internal Revenue Code.  They are cash-settled - meaning there is no underlying equity securities - and based upon a stock index, such as the Dow Jones Industrials (DJX) or the Standard & Poors 500 (SPX).


A 1256 Contract is settled at fair market value on the last business day of the year and the gain or loss is recognized.  This can be good or this can be bad.


The amount recognized is taxed according to the 60/40 rule:

  • 60% of the gain/loss is recognized as long-term

  • 40% of the gain/loss is recognized as short-term

The resulting net gain/loss is reported by broker by account number on Form 6781.  An example of that form is shown here.


For example, any gains recognized in one year are deemed to be sold on the last business day of the year.  Subsequently, the held option is also deemed to be repurchased on the same day with a new cost basis equal to the deemed selling price from the previous year.


The downside in the above example is that the taxpayer must pay for the deemed sale and subsequent tax liability with real cash.

 

Brokerage statements, especially December statements, provide a valuable resource for preparing Schedule D/Form 8949.  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 were required to report cost basis to the IRS along with sales (proceeds) of stock and option transactions.  This had “disaster” written all over it … and indeed it has been.

One of the most important sections of the brokerage statement is the open positions section, which should detail the open stock and option dollar 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 recent Options Symbology Initiative should no longer create a temporary consistency issue for “trades in progress” and 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 need to reconcile the difference.

Brokerage Statements & Form 1099
 
Current Year/Subsequent Year Transactions

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.

 

But for now, when you reconcile your option sales provided on your Form 1099-B to your Form 8949/Sch D, you will have to subtract December option sales not recognized and add prior year December sales that will be recognized in the current year.

For what it's worth, and this in no way describes official IRS policy, in a recent discussion with a Revenue Agent, she revealed to me that when the Schedule D/Form 8949 ties to the Form 1099-B it is assumed that the tax forms are correctly reported ... in other words, they do not tie out cost basis.

 
Assignment and Exercise

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 (exercised by) the holder of the call.  The purchase price of the call increases the basis in the stock purchased via the assignment process.

When a put is purchased and is ITM at expiration the proceeds of the underlying security includes the cost of the put.  So if you paid $250 for the put and the strike price was 50, your proceeds are $4,750 (100 shares x $50 - $250 put premium).

When a short call is exercised the proceeds from the sale of the underlying includes the premium received from the sale of the call.  So if you received $350 for the sale of the call with a strike of 75, your proceeds would be $7,850 (100 shares x $75 + $350 call premium). 

Brokerages are now required to report basis to IRS.

This represents one more reconciliation challenge when comparing your Form 8949 to what is reported on Form 1099-B and your option sales.

Note:  Most software packages for reporting the taxation of option trades DO NOT apply these rules.  The rules, prescribed by IRS (Pub 550), may actually benefit the taxpayer.  Click here for a table describing tax requirements for Put and Call holders and writers.

 
Tax for Investors and Traders

As stated on the About page, this website does not cover the tax issues associated with commodities, currency or futures ... except to mention this new tax ... the Net Investment Income Tax.


This tax is a surcharge of 3.8% applied to individuals (and trusts and estates) with net investment income or adjusted gross income over a threshold amount and includes trade or business income and gains.


For investors whose trade or business income is passive - as defined in IRC Sec 469 as the conduct of any trade or business in which the taxpayer does not materially participate - and who exceed the AGI threshold, there may be no avoiding this tax.


Specifically included are businesses whose income relates to the trading in financial instruments under IRC Sec 475(e)(2) which pertains solely to commodities.  IRC Sec 475(f)(2) represents the trading of securities and is not specifically included in this provision - but how long will that last?


No mention is made of the inclusion of tax-exempt interest on state and municipal bonds.
The tax is assessed on Form 8960 and specifically includes - in pertinent part - taxable interest, ordinary dividends and net gain or loss from the disposition of property - Schedules B and D.


Long-term capital gains may increase from the current maximum 20% rate.  Thus, these capital gains have the potential for staying the same, increasing to 18.8% or potentially 23.8% at the maximum rate.


The NIIT provision took effect in 2013.


Another tax - the Additional Medicare Tax - is also covered under this provision but impacts wage-earners with Medicare wages (Form W-2, Box 5) that exceed $200,000.  This tax is assessed on Form 8959.  The rate is 0.9% and is withheld by the employer from the employee and there is no employer match.