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.
Capital Gains & Losses
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.
Mark to Market is ALWAYS 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.
First-In First-Out - FIFO Identification
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.
Note: Some brokers allow investors to specifically identify shares online instead of in writing.
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.
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16 Sep 2022 150 long calls on AAPL are purchased in April 2022 at $10 per contract.
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10 Jun 2022 150 strike calls are sold for $3 per contract and expire worthless.
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Then, 16 Sep 2022 160 strike calls are sold for $2 per contract and expire worthless.
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On Sep expiration date AAPL is at $159 and the long calls are sold for $9
Transaction 1: The Jun 22 150 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 22 160 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 22 150 long call was sold for $9000 generating a $1000 short-term capital loss [($9 - $10) x 10 contracts x 100 shares/contract]
For a TIS, 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. For a MTMT, the detail supporting Form 4797 will also show three lines.
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:
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60% of the gain/loss is recognized as long-term
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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 & Form 1099
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 inconsistency 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 Form 8949/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.