How Are Covered Calls Taxed? Key Rules and Reporting Explained
Understand the tax treatment of covered calls, including premium income, holding periods, expiration, assignment, and reporting requirements.
Covered calls are a popular options strategy used by investors to generate extra income from stocks they already own. While the potential for additional returns is appealing, understanding how these trades are taxed is essential to avoid surprises. The tax treatment depends on whether the option expires, is assigned, or is closed early.
Tax rules for covered calls affect both short-term and long-term gains and can impact the holding period of the underlying stock. Knowing these details ensures accurate reporting and helps investors make informed decisions.
Premium Income Treatment
When selling a covered call, the investor receives a premium, which is considered taxable income. The timing and classification of this income depend on how the option contract plays out. The IRS treats option premiums as capital gains rather than ordinary income, meaning they are subject to capital gains tax rates instead of higher wage or interest income rates.
If the covered call is closed before expiration by buying back the option, the difference between the premium received and the cost to close the position results in a capital gain or loss. For example, if an investor sells a covered call for $3 per contract and later buys it back for $1, they realize a $2 per contract short-term capital gain. If they buy it back for $5, they incur a $2 per contract short-term capital loss. Since covered calls are written on stocks the investor already owns, the premium is typically classified as a short-term gain, regardless of how long the underlying stock has been held.
If the option is exercised, the premium is incorporated into the stock transaction rather than being taxed separately. If the stock is sold due to assignment, the premium effectively reduces the cost basis, increasing the taxable gain or decreasing the taxable loss. For example, if an investor owns shares purchased at $50 and sells a covered call for $2, then the stock is assigned at a $55 strike price, the taxable gain is calculated as if the shares were sold for $57 ($55 strike price + $2 premium).
Holding Period Implications
The holding period of the underlying stock determines whether gains are taxed as short-term or long-term. Writing a covered call can affect this period, particularly if the option is “in the money” at the time of sale. If the call is in the money by more than one strike price when sold, the IRS may suspend the holding period. This means that even if the investor had held the shares long enough to qualify for long-term capital gains, the clock effectively stops, and any subsequent sale of the stock could be taxed at the higher short-term rate if the holding period remains below one year.
Rolling covered calls—closing an existing call and selling a new one with a later expiration—can extend this suspension. Investors who repeatedly sell covered calls on the same stock may unknowingly delay long-term capital gains eligibility indefinitely.
When the Call Expires
If a covered call expires worthless, the seller keeps the premium without further obligation. Since no shares are sold, the premium is reported as a short-term capital gain. Unlike assigned options, where the premium adjusts the stock’s cost basis, an expired option does not affect the original purchase price of the shares.
Investors who frequently sell covered calls on the same stock should be aware that while the premiums generate income, they do not change the tax treatment of the shares. Any future sale of the stock is taxed based on the original acquisition cost.
When the Call Is Assigned
When a covered call is assigned, the seller must deliver their shares at the strike price, triggering a taxable event. If the shares were held for more than a year, any capital gain is taxed at long-term rates (0%, 15%, or 20%, depending on income level). If held for a year or less, the gain is taxed at short-term rates, which align with ordinary income tax brackets.
The timing of assignment can also impact taxes. If exercised just before an ex-dividend date, the seller may miss out on a qualified dividend that would have been taxed at a lower rate. Additionally, assignment during a market downturn could result in a realized gain even if the stock is trading below its original purchase price, as the strike price determines the sale amount rather than the current market value.
Reporting Requirements
Properly reporting covered call transactions ensures compliance with IRS regulations. The reporting method depends on whether the option expired, was assigned, or was closed early.
If a covered call expires worthless, the premium received is reported as a short-term capital gain on IRS Form 8949 and Schedule D. If the option is assigned, the premium is incorporated into the stock’s cost basis, and the resulting gain or loss is reported when filing taxes. If the call is closed early by buying it back, the difference between the sale and repurchase price is recorded as a capital gain or loss.
Brokerages typically issue Form 1099-B, summarizing these transactions, but investors should verify the accuracy of reported figures, as adjustments may be needed for cost basis calculations.