Taxation of Option Transactions
Taxation of option transactions is no simple matter. Here we attempt to illustrate the basic principles.
Profits and losses on options trading are treated as capital gains and losses. Therefore, options profits and losses are subject to all the regular rules that pertain to all capital gains and losses. In general, long-term capital gains qualify for favorable tax treatment.Capital losses offset capital gains and thereby reduce taxable income. However, capital losses are deductible only up to the amount of capital gains plus $3,000. Any excess capital loss cannot be decucted, but must be carried forward to offset capital gains in subsequent years.
The tax treatment differs for buyers and sellers of options and the tax treatment becomes very complicated for combinations of options. Here, we consider the four simplest stock option positions: long a call, short a call, long a put, or short a put.
Long a Call
If a call is exercised, the price of the option, the exercise price, and the brokeage commissions associated with purchasing and exercising the option are treated as the cost of the stock for tax purposes. If the option is sold before expiration, the capital gain or loss is the sale price of the option minus the purchase price of the option minus any brokerage fees incurred.
Short a Call
When a trader sells a call, the premium that is received is not treated as immediate income. If the call expires without being exercised, the gain on the transaction equals the price of the option less any brokerage fees, and this gain is always treated as a short-term gain. If the trader offsets the position before expiration, the capital gain or loss equals the sale price minus the purchase price minus any commissions, and this gain or loss is considered a short term gain or loss. If the call is exercised against the trader, the strike pirce plus the premium received minus any commissions becomes the sale price of the stock for determining the capital gain or loss.The gain or loss will be short-term or long-term depending on how the stock that is delivered was acquired.
Long a Put
If a put is purchased and sold before expiration, the gain or loss equals the sale price minus the purchase price minus any brokerage commissions, and the gain or loss will be short-term or long-term depending on how long the put was held. If the put expires worthless, the loss equals the purchase price plus the brokerage commissions, and the loss can be either short-term or long-term. If the trader exercises the put, the cost of the put plus commission reduces the amount realized upon the sale of the stock delivered to satisfy the exercise. The resulting gain or loss can be either short-term or long-term depending on how long the delivered stock was held.
Short a Put
The premium received for selling a put is not classified as income until the obligation from the sale of the put is completed. if the trader offsets the short put before expiration, the capital gain or loss equals the sale price minus the purchase price minus the brokerage commissions, and the resulting gain or loss is always a short term gain or loss. If the put expires worthless, the capital gain equals the sale price less the brokerage commissios, and the capital gains is a short-term gain. If the put is exercises against the trader, the basis of the stock acquired in the exercise equals the strike price plus the commission minus the premium received when the put was sold. The holding period for determining a capital gain or loss begins for the stock on the day following the exercise.