Capital Gains Tax on Put and Call Options

Options are contracts giving a buyer the right to buy or sell an underlying asset at a set price. A call option provides the right to buy, while a put option provides the right to sell. The tax consequences of these trades depend on the final outcome of the contract. Whether an option is sold, expires worthless, or is exercised determines how gains and losses are calculated and classified for tax purposes.

Tax Treatment of Closing or Expiring Options

The most frequent outcomes for option traders involve either closing a position before expiration or letting the contract expire. For the option buyer, selling an option to another party in a “closing sale” results in a capital gain or loss. This is calculated by subtracting the original premium from the sale price. If the option was held for one year or less, the result is a short-term capital gain or loss; if held for more than one year, it is long-term.

If the buyer holds the option until it expires without value, the buyer realizes a capital loss equal to the entire premium paid for the contract. The holding period of the option still dictates whether this is a short-term or long-term loss. For instance, if an investor buys a call option for a $300 premium and it expires worthless eight months later, they incur a $300 short-term capital loss.

For the option seller, often called the writer, the tax rules are distinct. If a writer exits their position, they execute a “closing purchase” by buying back the same option they initially sold. The resulting gain or loss is the difference between the premium they originally received and the cost to buy the option back. This transaction always results in a short-term capital gain or loss, regardless of how long the position was open.

When an option sold by a writer expires worthless, the entire premium received by the writer is recognized as a short-term capital gain. This is true even if the option contract had a duration longer than one year. For example, if a writer receives a $500 premium for selling a put option and the contract expires out-of-the-money, the writer reports a $500 short-term capital gain for the tax year in which the option expires.

Tax Consequences of Exercising Options

When an option is exercised, no immediate gain or loss is recognized on the option contract at the moment of exercise. Instead, the option’s cost or the premium received adjusts the tax basis or the sale proceeds of the stock, which has important consequences for future tax calculations.

When a Call Option is Exercised

When a buyer exercises a call option, they purchase the underlying stock. The premium paid for the call is added to the stock’s strike price to determine the total cost basis of the newly acquired shares. For example, if an investor pays a $2 premium per share for a call option with a $50 strike price, their cost basis in the stock upon exercise is $52 per share. The holding period for this stock begins the day after the option is exercised.

For the writer of the call option, being exercised forces them to sell their shares of the underlying stock. The premium they received for writing the option is added to the strike price to calculate the total amount realized from the sale. If the writer received a $3 premium for a call with a $100 strike price, their sale price becomes $103 per share. The resulting capital gain or loss is determined by comparing this amount to their original cost basis in the stock, and its character depends on the stock’s holding period.

When a Put Option is Exercised

When a buyer exercises a put option, they are selling stock they own. The premium they paid for the put option reduces the amount realized from this sale. If an investor sells stock at a $75 strike price through a put option for which they paid a $4 premium, their effective sale price for tax purposes is $71 per share. The gain or loss is based on this adjusted sale price and their basis in the stock, with the character determined by the stock’s holding period.

The writer of a put option who is exercised must buy the underlying stock. The premium they received for selling the put reduces their cost basis in the shares they are now required to purchase. If a writer received a $5 premium for a put with a $90 strike price, their basis in the stock they buy is $85 per share. The holding period for these newly acquired shares begins on the date of purchase.

Special Rules for Non-Equity and Index Options

A separate set of tax rules applies to Section 1256 contracts. These rules cover most non-equity options, which include options on broad-based stock indexes like the S&P 500, foreign currencies, and certain commodities futures.

The first rule is the “mark-to-market” system. Under this rule, any Section 1256 contracts held at the end of the tax year are treated as if they were sold at their fair market value on that day. This means that traders must recognize all gains and losses on their open positions annually, even if they haven’t actually closed the trade.

The second rule is the “60/40” rule. All capital gains and losses on Section 1256 contracts are treated as 60% long-term and 40% short-term, regardless of the actual holding period. For example, a trader who realizes a $20,000 gain on an index option held for only two weeks would not report it as a 100% short-term gain.

Instead, under the 60/40 rule, $12,000 (60%) of the profit would be classified as a long-term capital gain, and the remaining $8,000 (40%) would be a short-term capital gain. This blended rate is often more favorable than the ordinary income rates that would apply to a short-term gain on a standard equity option.

Reporting Option Trades on Tax Forms

Properly reporting option trades requires using specific tax forms based on the type of option traded. Brokers provide Form 1099-B with trading activity, but the taxpayer is responsible for correctly transferring this information to their tax return. The path for reporting differs between standard equity options and Section 1256 contracts.

Reporting Equity Options

Gains and losses from trading standard equity options are reported on Form 8949, Sales and Other Dispositions of Capital Assets. This form is used to detail each individual transaction. Taxpayers must list the description of the option, dates of acquisition and disposition, sale price, and cost basis. The net gain or loss from Form 8949 is then carried over to Schedule D, Capital Gains and Losses.

Taxpayers must check the appropriate box on Form 8949 that corresponds to how the transaction was reported by their broker on Form 1099-B, which indicates whether the cost basis was reported to the IRS.

Reporting Section 1256 Contracts

The reporting process for Section 1256 contracts is different. These transactions are not reported on Form 8949. Instead, traders must first calculate their aggregate gain or loss on Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. This form is where the mark-to-market accounting and the 60/40 split are applied.

Part I of Form 6781 is used to tally the gains and losses from all Section 1256 contracts for the year. The net result is then split into its 60% long-term and 40% short-term components directly on this form. The final net gain or loss figure from Form 6781 is then transferred directly to Schedule D.