Tax Considerations for Equity Options
Tax Considerations for Equity Options
Options trading creates taxable events that differ from stock transactions. Understanding when taxes apply, how to calculate gains and losses, and special rules like wash sales helps you manage tax liability and maintain accurate records.
Definition and Key Concepts
Capital Gains and Losses
Options produce capital gains or losses, not ordinary income (with some exceptions). The tax rate depends on the holding period:
- Short-term capital gains: Positions held one year or less, taxed at ordinary income rates
- Long-term capital gains: Positions held more than one year, taxed at preferential rates (0%, 15%, or 20% depending on income)
Most options positions are short-term because they're held for less than a year.
Taxable Events
A taxable event occurs when you:
- Sell an option you purchased (closing a long position)
- Buy back an option you sold (closing a short position)
- Let an option expire worthless
- Exercise an option (modifies cost basis, may not trigger immediate tax)
- Get assigned on a short option (modifies proceeds, may not trigger immediate tax)
| Event | Immediate Tax Consequence |
|---|---|
| Close long option for profit | Short-term capital gain |
| Close long option for loss | Short-term capital loss |
| Option expires worthless (long) | Short-term capital loss |
| Close short option for profit | Short-term capital gain |
| Close short option for loss | Short-term capital loss |
| Exercise long call | No immediate tax; adjusts stock cost basis |
| Assigned on short put | No immediate tax; adjusts stock cost basis |
Holding Period
The holding period for an option begins the day after purchase. If you hold a call for 13 months and sell it, the gain is long-term. However, if you exercise the call, the holding period for the resulting stock starts fresh from the exercise date.
How It Works in Practice
Long Option Tax Treatment
Purchase and Sale: You buy 1 XYZ $50 call for $3.00 and sell it for $5.00 three months later.
- Proceeds: $500 (5 × 100 shares)
- Cost Basis: $300 (3 × 100 shares)
- Capital Gain: $200 (short-term)
Expiration Worthless: You buy 1 ABC $100 call for $4.50 and it expires worthless.
- Proceeds: $0
- Cost Basis: $450
- Capital Loss: $450 (short-term)
The loss offsets other capital gains or up to $3,000 of ordinary income annually, with excess losses carrying forward.
Short Option Tax Treatment
Premium Collection and Buyback: You sell 1 DEF $40 put for $2.00 and buy it back for $0.50 two months later.
- Proceeds: $200 (premium received)
- Cost Basis: $50 (premium paid to close)
- Capital Gain: $150 (short-term)
Note: Even though you received money first, the IRS treats premium received as proceeds and premium paid as cost.
Expiration Worthless (Short Option): You sell a covered call for $1.50 and it expires worthless.
- Proceeds: $150
- Cost Basis: $0
- Capital Gain: $150 (short-term)
Exercise and Assignment Tax Treatment
Long Call Exercised: You buy 1 GHI $60 call for $5.00 and exercise when GHI is at $70.
- Option cost: $500
- Shares received: 100 shares at $60
- Stock cost basis: $60 + $5 = $65 per share
No immediate tax. The gain or loss is realized when you sell the shares.
Short Put Assigned: You sell 1 JKL $45 put for $2.00 and are assigned when JKL is at $40.
- Premium received: $200
- Shares received: 100 shares at $45
- Stock cost basis: $45 - $2 = $43 per share
No immediate tax. You own shares with a $43 cost basis.
Worked Example
Full Trade Cycle with Tax Implications
January 15: Buy 1 XYZ $50 call for $4.00 ($400 cost) March 20: Sell the call for $7.50 ($750 proceeds)
Tax Calculation:
- Holding period: 64 days (short-term)
- Gain: $750 - $400 = $350
- Tax treatment: Short-term capital gain
If your marginal tax rate is 24%, federal tax on this trade is approximately $84.
Alternative Scenario: Exercise
January 15: Buy 1 XYZ $50 call for $4.00 ($400 cost) March 20: Exercise the call (XYZ at $58) September 15: Sell 100 shares at $65
Tax Calculation:
- Stock cost basis: $50 strike + $4 premium = $54 per share
- Sale proceeds: $65 per share
- Gain per share: $11
- Total gain: $1,100
- Holding period: March 20 to September 15 = 179 days (short-term)
- Tax treatment: Short-term capital gain
| Scenario | Gain | Holding Period | Tax Rate |
|---|---|---|---|
| Sell option | $350 | 64 days | Ordinary income |
| Exercise and sell | $1,100 | 179 days | Ordinary income |
| Exercise and hold >1 year | $1,100 | >365 days | Long-term capital gains |
Risks, Limitations, and Tradeoffs
Wash Sale Rules
The wash sale rule disallows losses when you purchase substantially identical securities within 30 days before or after the loss sale. For options:
- Selling a stock at a loss and buying a call on the same stock triggers a wash sale
- Selling an option at a loss and repurchasing a substantially identical option may trigger a wash sale
- The disallowed loss adds to the cost basis of the replacement position
Careful planning is needed to harvest losses without triggering wash sales.
Straddles and Tax Complications
If you hold offsetting positions (like a stock and a put, or a call and a put), special straddle rules may:
- Defer losses
- Extend holding periods
- Limit loss deductions
These rules are complex and may require professional tax advice.
Section 1256 Contracts
Certain options—specifically broad-based index options like SPX—qualify as Section 1256 contracts, receiving:
- 60% long-term / 40% short-term treatment regardless of holding period
- Mark-to-market taxation (unrealized gains/losses taxed annually)
Most equity options do NOT qualify for Section 1256 and receive standard capital gains treatment.
Record Keeping Requirements
Track for each trade:
- Trade date
- Underlying and option details
- Premium paid or received
- Commission and fees
- Closing transaction details
- Exercise/assignment records
Brokers provide 1099-B forms, but you're responsible for accurate reporting.
Common Pitfalls
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Ignoring wash sale implications: Trading similar options within the 30-day window can disallow losses.
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Miscalculating cost basis after exercise: Remember to add option premium to strike price for exercised calls.
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Forgetting to report expired options: A worthless option still creates a tax event that must be reported.
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Assuming all index options get 60/40 treatment: Only broad-based index options qualify; sector or narrow-based indexes may not.
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Not tracking short-term vs. long-term: Nearly all options trades are short-term, but occasional long-term trades have better tax rates.
Checklist for Option Tax Management
- Track all opening and closing transactions with dates and amounts
- Calculate gains/losses separately for each closed position
- Identify wash sale situations before trading
- Adjust cost basis for exercised or assigned options
- Verify holding periods for long-term vs. short-term classification
- Check if positions create straddle tax complications
- Review 1099-B for accuracy against your records
- Consider tax-loss harvesting before year-end
Next Steps
Understanding margin requirements is essential for options trading. Learn how Reg T and portfolio margin affect your positions in Reg T and Portfolio Margin Treatment.
For background on the OCC clearing process that generates your tax records, see Clearing and OCC Guarantees.
This article provides general information and is not tax advice. Consult a qualified tax professional for guidance on your specific situation.