Taxation

Taxation of option transactions is no simple matter. We cannot hope to cover all of the nuances of the tax laws in this brief section. Further, the passage of the 1993 tax act further complicates matters in ways that have not been fully resolved at this writing. Therefore, this section attempts merely to illustrate the basic principles.

Disposition of an option, either through sale, exercise, or expiration gives rise to a profit or loss. Profits and losses on options trading are treated as capital gains and losses. Therefore, options profits and losses are subject to all the regular rules that pertain to all capital gains and losses. Capital gains may be classified as long-term or short-term capital gains. A capital gain is a long-term gain if the instrument generating the gain has been held longer than one year, otherwise the gain or loss is short-term. In general, long-term capital gains qualify for favorable tax treatment.

Capital losses offset capital gains and thereby reduce taxable income. However, capital losses are deductible only up to the amount of capital gains plus $3,000. Any excess capital loss cannot be deducted, but must be carried forward to offset capital gains in subsequent years. For example, assume that a trader has capital gains of $17,500 from securities trading. Unfortunately for the trader, he also has $25,000 in capital losses. Therefore, $17,500 of the losses completely offset the capital gains, freeing the trader from any taxes on those gains. This leaves $7,500 of capital losses to consider. The trader can then use $3,000 of this excess loss to offset other income, such as wages. In effect, this protects $3,000 of wages from taxation. The remaining $4,500 of losses must be carried forward to the next tax year, where it can be used to offset capital gains realized in that tax year.

Option transactions give rise to capital gains and losses, and the tax treatment differs for buyers and sellers of options. Further, the tax treatment becomes very complicated for combinations of options. Therefore, we consider only the four simplest stock option positions: long a call, short a call, long a put, or short a put.

Long a Call

If a call is exercised, the price of the option, the exercise price, and the brokerage commissions associated with purchasing and exercising the option are treated as the cost of the stock for tax purposes. The holding period for the stock begins on the day after the call is exercised, so the stock must be held for a year to qualify for treatment as a long-term capital gain. If the call expires worthless, it gives rise to a short-term or long-term capital loss equal to the purchase price of the option plus any associated brokerage fees incurred in purchasing the option. If the option is sold before expiration, the capital gain or loss is the sale price of the option minus the purchase price of the option minus any brokerage fees incurred.

Short a Call

When a trader sells a call, the premium that is received is not treated as immediate income. Instead, the treatment of this premium depends on the disposition of the short call. If the call expires without being exercised, the gain on the transaction equals the prices of the option less any brokerage fees, and this gain is always treated as a short-term gain, no matter how long the position was held. If the trader offsets the position before expiration, the capital gain or loss equals the sale price minus the purchase price minus any commissions, and this gain or loss is considered a short-term gain or loss without regard to how long the position is held. If the call is exercised against the trader, the strike price plus the premium received minus any commissions becomes the sale price of the stock for determining the capital gain or loss. The gain or loss will be short-term or long-term depending on how the stock that is delivered was acquired. For example, if the trader delivers stock that had been held for more than one year, the gain or loss would be a long-term gain or loss.

Long a Put

If a put is purchased and sold before expiration, the gain or loss equals the sale price minus the purchase price minus any brokerage commissions, and the gain or loss will be short-term or long-term depending on how long the put was held. If the put expires worthless, the loss equals the purchase price plus the brokerage commissions, and the loss can be either short-term or long-term. If the trader exercises the put, the cost of the put plus commission reduces the amount realized upon the sale of the stock delivered to satisfy the exercise. The resulting gain or loss can be either short-term or long-term depending on how long the delivered stock was held.

Short a Put

The premium received for selling a put is not classified as income until the obligation from the sale of the put is completed. If the trader offsets the short put before expiration, the capital gain or loss equals the sale price minus the purchase price minus the brokerage commissions, and the resulting gain or loss is always a short-term gain or loss. If the put expires worthless, the capital gain equals the sale price less the brokerage commissions, and the capital gain is a short-term gain. If the put is exercised against the trader, the basis of the stock acquired in the exercise equals the strike price plus the commission minus the premium received when the put was sold. The holding period for determining a capital gain or loss begins for the stock on the day following the exercise.

There are other special and more complicated rules for taxing options transactions, so the account here is not definitive. Additional complications arise for some options on stock indexes, for example. Also, there are special tax rules designed to prevent options trading merely to manipulate taxes.

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