How Much Tax Do You Pay on Options Trading?

Understanding the tax implications of options trading is important for any participant. A clear grasp of tax rules is essential for proper reporting and managing potential tax liabilities. This overview clarifies how various options transactions are treated for tax purposes.

General Tax Rules for Options Trading

Gains and losses from options transactions are treated as capital gains and losses for federal income tax purposes, classified by holding period. Short-term capital gains and losses apply to assets held for one year or less, while long-term capital gains and losses apply to assets held for more than one year. Short-term capital gains are taxed at an individual’s ordinary income tax rates. Long-term capital gains receive preferential tax treatment, with rates of 0%, 15%, or 20%.

The holding period for an option begins on the day after acquisition and ends on the day it is disposed of through sale, exercise, or expiration.

Premiums paid when purchasing an option contribute to its cost basis. If exercised, this premium is added to the cost basis of the underlying asset. Conversely, premiums received when writing or selling an option are considered income if the option expires unexercised, or they reduce the cost basis of the underlying asset if exercised against the writer.

If trading activities result in a net capital loss for the year, taxpayers can deduct up to $3,000 of that loss against their ordinary income annually. Any capital losses exceeding this limit can be carried forward indefinitely to offset capital gains in future tax years.

Section 1256 Contracts and Their Taxation

Certain options and financial instruments are categorized as Section 1256 contracts. These include:
Regulated futures contracts
Foreign currency contracts
Non-equity options (such as broad-based index options)
Dealer equity options
Dealer securities futures contracts
Options on individual stocks or exchange-traded funds (ETFs) are not considered Section 1256 contracts.

Section 1256 contracts feature the “mark-to-market” rule. This rule requires taxpayers to treat all contracts held at year-end as if sold at fair market value on the last business day. Any unrealized gains or losses are recognized and taxed for that year.

Section 1256 contracts also follow the “60/40 rule.” This rule stipulates that 60% of any gain or loss is treated as long-term capital gain or loss, and 40% as short-term. This allocation applies regardless of the holding period, offering a tax advantage.

Taxpayers can elect to carry back losses from Section 1256 contracts. If a net Section 1256 loss occurs, it can be carried back up to three years to offset net Section 1256 gains in prior years, potentially resulting in a tax refund.

Understanding Specific Options Transactions for Tax Purposes

When an option is bought and sold before expiration or exercise, the resulting gain or loss is treated as a capital gain or loss. This is based on the difference between the sale price and the initial premium paid, adjusted for commissions. The option’s holding period determines if the gain or loss is short-term or long-term.

If an option expires worthless, the premium paid is considered a capital loss for the tax year of expiration.

Exercising options has specific tax implications. When a call option is exercised, the premium paid is added to the cost basis of the acquired stock. Conversely, when a put option is exercised, the premium paid reduces the proceeds from the sale of the underlying stock.

Writing (selling) options carries distinct tax consequences. If an option is written and then expires worthless, the premium received by the writer is treated as a short-term capital gain. However, if the written option is a Section 1256 contract, the premium is subject to the 60/40 rule.

When a written option is exercised, tax treatment varies by option type. For a covered call that is exercised, the premium received by the writer increases the total proceeds from the stock sale. For a naked put that is exercised, the premium received reduces the cost basis of the subsequently purchased stock.

The wash sale rule applies to options, potentially disallowing losses from the sale of an option if a substantially identical option or security is acquired within 30 days before or after the sale. This rule prevents claiming artificial losses, postponing loss recognition.

Reporting Options Trades on Your Tax Return

Brokers provide Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions,” summarizing sales proceeds from options and other securities for the tax year. It details property description, acquisition and sale dates, and sales price.

Taxpayers use Form 8949, “Sales and Other Dispositions of Capital Assets,” to report options trades as provided on Form 1099-B. Form 8949 has separate sections for short-term and long-term transactions.

The totals from Form 8949 are transferred to Schedule D, “Capital Gains and Losses,” where the net capital gain or loss for the year is calculated. Schedule D aggregates all capital gains and losses from various sources, including options, stocks, and other investments.

For Section 1256 contracts, taxpayers must report gains and losses on Form 6781, “Gains and Losses From Section 1256 Contracts and Straddles.” The net gain or loss calculated on Form 6781 is then transferred to Schedule D.

Maintaining accurate records beyond brokerage statements is important for all options traders. This includes trade confirmations, account statements, and other documentation supporting reported gains, losses, and basis adjustments. Record-keeping aids in IRS inquiries and tracking carryover losses.