How Are Options Trades Taxed?

Options trading is increasingly accessible. Understanding its tax implications is important for participants. This guide clarifies how options activities are treated for tax purposes in the United States, providing foundational rules and reporting requirements.

Basic Principles of Options Taxation

Most options transactions are treated as capital gains or losses. Short-term (held one year or less) are taxed at ordinary income rates. Long-term (held more than one year) receive preferential lower rates, depending on income bracket.

The cost basis of a purchased option is its premium. This basis determines the gain or loss when sold or expired. When an option position is closed, the difference between selling price and cost basis determines the capital gain or loss. For expired long options, the premium paid becomes a capital loss.

Options activity can lead to ordinary income, but for general trading, the focus is on capital gains and losses. This distinction is important due to different tax treatments.

The wash sale rule prevents deducting a loss on stock or security sales if substantially identical items are acquired within 30 days before or after. This applies to options and underlying securities. The disallowed loss is added to the newly acquired security’s cost basis.

Tax Implications of Common Options Scenarios

Tax consequences vary by expiration, closure, exercise, or assignment. When a long option expires worthless, the premium paid is a capital loss (short-term or long-term based on holding period). For instance, a call option purchased two months ago expiring unexercised results in a short-term capital loss.

Closing an options position involves selling a long option or buying back a short option. Selling a purchased long option for more than its premium is a capital gain; for less, a capital loss. Holding period determines if the gain or loss is short-term or long-term.

When an investor sells a call or put option (short position), they receive a premium. Buying back for less than the premium is a capital gain; for more, a capital loss. These are short-term gains or losses, as short options are not held for long-term treatment.

Exercising a long call option means purchasing the underlying stock. The premium paid is added to the acquired shares’ cost basis. For example, a $200 premium call option exercised to buy 100 shares at $50 each makes the cost basis $5,200 ($5,000 exercise + $200 premium). The stock’s holding period begins the day after exercise.

When a short call option is assigned, the writer sells the underlying stock. The premium received reduces stock sale proceeds. For instance, a $300 premium call assigned, selling 100 shares at $60 each, yields net proceeds of $6,300 ($6,000 stock sale + $300 premium). Stock gain or loss is calculated using adjusted proceeds and cost basis.

Exercising a long put option means selling the underlying stock. The premium paid reduces sale proceeds. For example, a $150 premium put option exercised to sell 100 shares at $40 each yields net proceeds of $3,850 ($4,000 exercise – $150 premium). Stock gain or loss is determined using adjusted proceeds and cost basis.

When a short put option is assigned, the writer purchases the underlying stock. The premium received reduces the acquired shares’ cost basis. If a $250 premium put is assigned, buying 100 shares at $70 each makes the cost basis $6,750 ($7,000 exercise – $250 premium). The stock’s holding period begins the day after assignment.

Covered calls involve writing call options against owned stock. If unexercised, the premium received is a short-term capital gain. If closed out, the difference between premium received and cost to close is a short-term capital gain or loss. If assigned, the premium increases the stock’s effective sale price, impacting its capital gain or loss, determined by its holding period.

Cash-settled options (e.g., S\&P 500 Index) do not involve physical asset delivery. Their value settles in cash at expiration or closure. Gains or losses are treated as capital gains or losses, following capital asset rules without basis adjustments for underlying stock.

Special Tax Rules for Certain Options

Certain options contracts fall under Section 1256 of the Internal Revenue Code. These include futures, foreign currency, and options on broad-based stock indexes (e.g., S\&P 500, Nasdaq 100). Individual stock or narrow-based index options do not qualify. This distinction is important due to unique tax treatment.

Section 1256 contracts are subject to the “mark-to-market” rule. All open contracts are treated as sold at fair market value on the last business day of the tax year. Gains or losses are recognized annually, creating taxable events even if the position has not been closed.

A benefit of Section 1256 contracts is the “60/40 rule.” Capital gains or losses are treated as 60% long-term and 40% short-term, regardless of holding period. This allows a portion of gains to be taxed at lower long-term rates, even for short-duration contracts, providing tax advantages for short-term traders.

For example, a contract held for only a few days would still have 60% of its gain or loss treated as long-term. The mark-to-market and 60/40 rules simplify tax reporting by eliminating the need to track individual holding periods for each trade in Section 1256 contracts.

Reporting Options Trades

Accurate reporting of options trades to the IRS is part of a trader’s annual tax obligations. Brokers report transactions on Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” This form details gross proceeds, acquisition date, cost basis for covered securities (including most options), and indicates short-term or long-term gain/loss.

Taxpayers use Form 1099-B information to complete Form 8949, “Sales and Other Dispositions of Capital Assets.” This form lists individual capital asset transactions, including options. Transactions are categorized by basis reporting to the IRS and short-term or long-term gain/loss. It provides a detailed breakdown of each trade, including property description, acquisition/sale dates, proceeds, and cost basis.

After individual options transactions are listed on Form 8949, totals transfer to Schedule D, “Capital Gains and Losses.” Schedule D summarizes capital gains and losses for the tax year from all sources, including those from Form 8949. It calculates the net capital gain or loss, which flows to Form 1040. This process consolidates all capital asset activity for tax calculation.

For Section 1256 contracts, reporting follows a different path due to unique tax treatment. Gains and losses are reported on Form 6781, “Gains and Losses From Section 1256 Contracts and Straddles.” This form calculates the 60% long-term and 40% short-term allocation under the 60/40 rule. The net gain or loss is carried over to Schedule D, combined with other capital gains and losses.

Maintaining records of all options trades is important. This includes trade confirmations, statements, and documentation supporting acquisition/sale dates, premiums, and basis adjustments. Accurate record-keeping ensures correct reporting and is helpful in case of an IRS inquiry.