taxes on options trades

In short

A friend of mine once sold a call option, watched the month go by, and then asked me when the tax bill would show up. If you have traded options, you have probably wondered the same thing. Most options gains and losses land on Schedule D and Form 8949, and your broker reports them on Form 1099-B. How long the position was held, and what kind of option it was, sets the tax rate. A short term gain is taxed like ordinary income, so it follows your regular bracket. A long term gain is taxed at a lower rate, but only if the position was held more than one year. Some index options get a special split, so it pays to know which kind you hold. Check your 1099-B each year before you file, because the numbers there are the ones the IRS sees.

The whole of it

What it is

I once watched a neighbor spend an entire Saturday sorting his brokerage statements, and he told me the trading was the easy part. The tax paperwork was what wore him out. That is a feeling a lot of honest folks share, and it is no mark against your intelligence.

An option is a contract. The buyer pays a price, called the premium, for the right to buy or sell a stock at a set price before a set date. The seller takes in that premium and agrees to meet the terms if the buyer acts. The tax treatment depends on which side the trader was on and how the contract ended.

There are a few ways a contract can end. It can be sold before it ends. It can expire worthless. It can be exercised, meaning the buyer uses the right. Or it can be assigned, meaning the seller is called on to deliver. Each ending has its own tax rule, and the differences matter.

How it works

If you are holding a bought option and you sell it, your gain or loss is the sale price minus what you paid. If it expires worthless, you have a loss equal to the premium you paid. Both are treated as capital gains or losses. The holding period decides whether the result is short term or long term.

Here is a thing that surprises people. When an option is exercised, the tax event usually moves into the stock. A buyer who exercises a call adds the premium to the cost of the shares. A buyer who exercises a put subtracts the premium from the sale price of the shares. The option itself does not produce a separate gain or loss in that case.

Sellers have their own rules. A person who sells an option takes in the premium, but the IRS does not treat that as income right away. The seller waits until the contract closes. If it expires worthless, the premium becomes a short term gain, no matter how long the contract was open. If the seller buys it back, the difference is a gain or loss. If the contract is assigned, the premium is folded into the stock sale or purchase.

Then there is the wash sale rule. If a taxpayer sells at a loss and buys a substantially identical position within thirty days before or after, the loss is disallowed for now. It is added to the cost of the new position instead. That phrase, substantially identical, is where the trouble sits.

Two cases deserve a plain look. In the first, a trader sells an option at a loss and then buys another option on the same stock. Whether the two are substantially identical depends on the terms. Two calls with the same strike price and nearly the same end date look much alike. Two calls with quite different strikes or dates may not.

In the second case, a trader sells a stock at a loss and then buys a call option on that same stock. Publication 550 says a loss can be disallowed when a taxpayer buys a contract or option to acquire substantially identical stock within the window. So the stock and the option can be tied together. It also works in reverse, because a loss on a closed option can be tied to a stock purchase. No bright line settles every pairing. The facts of each trade matter, and a tax preparer can help with the gray ones.

Some options follow a different path. Broad based index options, and certain futures options, fall under Section 1256 of the tax code. The tax code gives those gains and losses a special split between long term and short term, and the share for each is set by Section 1256 and shown on Form 6781, whatever the holding time. They are also marked to market at year end, which means treated as sold at their closing price on December 31.

The numbers, and where to find yours

I have always found that a person feels calmer once they know where the numbers live. Your broker sends Form 1099-B each year, and it lists your sales, your cost basis, and whether each result is short term or long term. For Section 1256 contracts, the broker reports on a separate part of that form, and the taxpayer files Form 6781.

The rates change by year, so this guide does not state them. Your short term gains are taxed at your ordinary rate, which is set by the bracket your income falls into. The bracket thresholds for this year are the current figure, which the official source publishes each year. Long term gains use their own rates, and the income cutoffs for those are the current figure, which the official source publishes each year. Some higher earners also owe the net investment income tax, and the income level where it begins is the current figure, which the official source publishes each year.

The wash sale window is thirty days on each side of a sale. That figure is set in the tax code, and you can read it in IRS Publication 550, called Investment Income and Expenses. That publication is the best plain source for how options are taxed. Form 8949 and its instructions explain how to list each trade.

A worked example

Let me tell you about a woman named Dana. She is a nurse who earns $52,000 a year, and she took up options as a side interest.

In March, Dana bought one call option contract on a stock. A contract covers 100 shares. She paid a premium of $2 a share, so 100 shares times $2 is $200. In May, she sold that contract for $5 a share, which is 100 times $5, or $500. She held it about two months, so the result is short term.

Her gain is $500 minus $200, which is $300. That $300 is added to her other income and taxed at her ordinary rate. If her bracket rate were 12 percent, the federal tax would be $300 times 0.12, which is $36. The rate here is an illustration only, so she should check the actual bracket in the current IRS tables.

Now picture a second trade. In June, Dana bought a put option and paid $1.50 a share. That is 100 times $1.50, or $150. The put expired worthless in July. She paid $150 and got nothing back, so her $150 premium is a short term loss. A bought option that expires worthless is a capital loss, and it is short term because she held it less than a year.

Now net the two. $300 of gain minus $150 of loss is $150 of short term gain for the year. At her illustrative 12 percent rate, the tax on that is $150 times 0.12, which is $18. Her 1099-B shows the first trade as a sale, and the second as an expired option. She lists both on Form 8949, carries the totals to Schedule D, and the result flows to her return.

Where it goes wrong

I have seen smart, careful people trip on this, and it is rarely a lack of effort. It is that the rules have a few quiet corners.

The first corner is the holding period. A person who closes an option on day 360 has a short term result, even if the stock was held for years. The clock for the option runs on its own.

The second is the wash sale. A loss can be pushed forward without the trader noticing, especially across several accounts. Brokers track it within one account, but the taxpayer is responsible for matching trades across accounts, as the broker's form instructions note. The pairing of an option with its stock, or with a similar option, is the part that catches people most.

The third is covered calls and the stock under them. A call that is too deep in the money can change how the holding period of the stock is counted. This is a tax rule called a qualified covered call test, and it is worth reading about in Publication 550 before relying on any assumption.

The fourth is mixing up the two types of index options. Only certain contracts qualify for the 60/40 split. A regular equity option does not. A person who assumes the better treatment may file wrong.

The last is simple. Basis errors on a 1099-B do happen. Check them. A wrong number there is still your number once you sign.

Questions to answer before you leave this page

Do you know whether each of your options was bought or sold, and how each one ended? Have you found your Form 1099-B, and does the cost basis on it match your own records? Which of your trades were held for a year or less, and which were held longer? Did you sell anything at a loss and then buy a close cousin of it within thirty days, whether that was the same stock, an option on that stock, or a very similar option? Do any of your contracts belong to the Section 1256 group that gets the 60/40 split? Have you looked up the current brackets and thresholds in the sources named above, rather than trusting a number from memory? And if your trades are many or tangled, would an hour with a tax preparer put your mind at ease?