By Hayden Adams Options trading is becoming more popular among investors, yet a lot of people don’t understand the tax implications of these transactions. Investors may be surprised by how complex the taxation of options can be. Let’s look at the key factors you need to consider when it comes to buying and selling options on the open market.IRS publication 550 and IRS Topic No. 429 Traders in Securities. Categories of options For tax purposes, options can be classified into three main categories: Employee stock options: These are generally options contracts given to employees as a form of compensation. For example, incentive stock options. Equity options: Options contracts on equities that can be traded on the open market. For example, puts or calls on individual stocks or on ETFs that hold stocks. Non-equity options: As the name infers, these are options contracts on something other than equities or ETFs, which can include commodities, futures or a broad-based stock market index. The IRS often refers to these options as “section 1256 contracts.” These types of options can also be traded on the open market. Examples include puts or calls on gold, pork belly futures, and even the S&P 500 index (more on this later). How Should Equity Compensation Fit Into Your Financial Plan” and “Understanding the Risks of Employee Stock Options.” Taxation of equity options The taxation of equity options is different for a long position (where you’re the buyer of the option) versus a short position (where you’re the seller/writer of the option). For those who have long or short options contracts, the tables below provide an overview of how these contracts are generally taxed. But be aware, if you’re doing more complex options transactions, such as spreads or butterflies, the IRS may consider those trades to be “straddle” contracts, which means they could be taxed differently (see below for more details). Taxation of complex equity options strategies Numerous options strategies are available to investors, such as writing covered calls, using spreads, straddles, strangles, butterflies, etc. Unfortunately, this is another situation where the IRS does not use the same language as investors, and that can lead to some confusion. The IRS groups most of these complex options strategies together and refers to them as a “straddle.” For tax purposes, a straddle occurs when you’re holding an options contract that offsets or substantially reduces the risk of loss to another position you’re also holding. For example, say you own stock in XYZ corporation and that stock in currently trading for $80 per share. If you bought a put option at a $70 strike price to protect against downside price movement, you have in essence limited your down-side risk, which means the IRS would consider that option to be a straddle and you must defer your loss (cost) on the put option. The idea behind the straddle taxation rules is to prevent investors from deducting losses before an offsetting gain is recognized. Here are the basics you need to know about how straddles are taxed: Losses on straddles are generally deferred: If only one side of a straddle position is closed, any realized losses are generally not deductible until the offsetting position is also closed out. Any losses are included in the basis of the remaining position and eventually recognized when the final position is closed. Note: Any loss that exceeds the unrecognized gain from an offsetting position can generally be deducted. Qualified covered calls (QCCs) are not subject to the straddle rules: The IRS groups covered calls into two categories, unqualified or qualified, and each is taxed differently. Generally, QCCs are options written with an expiration date greater than 30 days and a strike price that is not “deep-in-the-money” (see IRS Publication 550 to learn more). If the covered call does not meet these requirements, then it’s considered “unqualified” and is taxed as a straddle. Offsetting section 1256 options are exempt from this rule: Straddles consisting entirely of Section 1256 options are not taxed as straddles (see more below). The wash sale rules generally apply to options The same wash sale rules that apply to stock also apply to stock option trades. If a substantially identical security is acquired within 30 days before or after the sale occurs, the loss is disallowed and the basis is transferred to the new position. Non-equity options taxation Internal Revenue Code section 1256 requires options contracts on futures, commodities, currencies and broad-based equity indices to be taxed at a 60/40 split between the long and short term capital gains rates.This rule means the taxation ofprofits and losses from non-equity options are not affected by how long you hold them. Section 1256 options are always taxed as follows: 60% of the gain or loss is taxed at the long-term capital tax rates 40% of the gain or loss is taxed at the short-term capital tax rates Note: The taxation of options contracts on exchange traded funds (ETF) that hold section 1256 assets is not always clear. Consult with a tax professional if you hold these types of investments. In addition to the 60/40 split rule, if you hold section 1256 options contracts over year-end into the new year, you’ll be required to recognize an unrealized gain or loss each year based on the fair market value on Dec. 31. This is known as the marked-to-market rule, and it applies even if you don’t sell that option. This activity also resets your cost basis (higher or lower) for the next calendar year. In addition, section 1256 contracts are not subject to the same wash sale rules as equity options. Bottom line The taxation of options can be even more complex than what was described above. That’s why we recommend that anyone who trades options consider working with a tax professional who has experience in options taxation so that you don’t end up paying more in taxes than is necessary.
For ETFs, what constitutes as substantially identical? If I had an assigned SPY covered call and the following day sold a VOO put contract, would that be considered substantially equivalent since they track the same index? Based on what I read in Pub 550 and my understanding, writing a put contract is categorized as reestablishing the position and thus, a wash sale. However, IBKR uses the stock symbol when identifying a wash sale, so I assume that it would not be identified by IBKR as a wash sale. As an individual investor though, should that be reported as a wash sale (and the loss adjusts the cost basis of the new position, VOO)? Thanks!
[QUOTE="the.goot.opts, post: 5665378, member: 534590 . As an individual investor though, should that be reported as a wash sale (and the loss adjusts the cost basis of the new position, VOO)? Thanks![/QUOTE] you should use a program or an accountant with a program to calculates your taxes.
I do have an accountant, and am using software that I’ve written to manage wash sale between accounts (taxable, and IRAs). I was and still am curious about what others here interpret “substantially equivalent” because there does not seem to be a consensus on it due to lack of specificity from the IRS. At the moment, I follow what brokers use, which is to use the same CUSIP ID to determine wash sale. Thanks!
for stocks the exact same. So two s&p 500 mutual funds would qualify. But if one of those mutual held 499 stocks then they are t substantially similar. I don’t know if class A and class B of the same company are considered similar when one has voting rights and the other doesn’t. I suspect not. It’s a very narrow definition from my understanding. for options moneyness is taken into account making. Selling an itm put is considered a long stock but an selling an otm put is not. It’s so complicated no one has the same answer on it. A lot of it is answered through court cases which makes it hard to find answers but judgement is required to figure out your circumstance.