Tax Ramifications in Trading Options
An especially complex area of risk involves taxes. If you are like most people, you understand how taxation works, generally speaking. When it comes to options, though, a few special rules apply that can decide whether a particular strategy makes sense.
Capital gains -- taxable profits from investments are broken down into short term or long term. The normal treatment of capital gains is determined by your holding period. If you own stock for 12 months or more and then sell, your profit is treated as long-term gain or loss; a lower tax percentage is applied than to short-term capital gains (gains on assets owned less than 12 months).
Here are 11 rules for option-related capital gains taxes:
- Short-term capital gains. Generally speaking, any investment you hold for less than 12 months will be taxed at the same rate as your other income (your effective tax rate). After 2003, this rate may be as high as 35 percent. The rate is scheduled to rise in 2010 unless further legislation is passed to change that.
- Long-term capital gains. For investments held for 12 months or more, a more favorable tax rate applies. The maximum rate of 15 percent on long-term gains applies to "net" capital gains (long-term capital gains less short-term capital losses). This rate lasts until the end of 2008 unless future revisions are made to make the favorable rates permanent.
- Constructive sales. You could be taxed as though you sold an investment, even when you did not actually complete a sale. This constructive sale rule applies when offsetting long and short positions are entered in the same security. For example, if you buy 100 shares of stock and later sell short 100 shares of the same stock, it could be treated as a constructive sale. The same rules could be applied when options are used to hedge stock positions. The determining factors include the time between the two transactions, changes in price levels, and final outcomes of both sides in the transaction. This is a complex area of tax law; if you are involved with combinations and short sales, you should consult with your tax adviser to determine whether constructive sale rules apply to your transactions.
- Wash sales. If you sell stock and, within 30 days, buy it again, it is considered a wash sale. Under the wash sale rule, you cannot deduct a loss when 30 days have not passed. The same rule applies in many cases where stock is sold and, within 30 days, the same person sells an in-the-money put.
- Capital gains for unexercised long options. Taxes on long options are treated in the same way as other investments. The gain is short term if the holding period is less than 12 months, and it is long term if the holding period is one year or more. Taxes are assessed in the year the long position is closed in one of two ways: by sale or expiration.
- Treatment of exercised long options. If you purchase a call or a put and it is exercised, the net payment is treated as part of the basis in stock. In the case of a call, the cost is added to the basis in the stock; and the holding period of the stock begins on the day following exercise. The holding period of the option does not affect the capital gains holding period of the stock. In the case of a long put that is exercised, the net cost of the put reduces the gain on stock when the put is exercised and stock is sold. The sale of stock under exercise of a put will be either long term or short term depending on the holding period of stock.
- Taxes on short calls. Premium is not taxed at the time the short position is opened. Taxes are assessed in the year the position is closed through purchase or expiration; and all such transactions are treated as short-term regardless of how long the option position remained open. In the event a short call is exercised, the striking price plus premium received become the basis of the stock delivered through exercise.
- Taxes on short puts. Premium received is not taxed at the time the short position is opened. Closing the position through purchase or expiration always creates a short-term gain or loss. If the short put is exercised by the buyer, the striking price plus trading costs becomes the basis of stock through exercise. The holding period of the stock begins on the day following exercise of the short put.
- Limitations of deductions in offsetting positions. The federal tax rules consider straddles to be offsetting positions. This means that some loss deductions may be deferred or limited, or favorable tax rates are disallowed. If risks are reduced by opening the straddle, four possible tax consequences could result. First, the holding period for the purpose of long-term capital gains could be suspended as long as the straddle remains open. Second, the wash sale rule may be applied against current losses. Third, current-year deductions could be deferred until an offsetting "successor position" (the other side of the straddle) has been closed. Fourth, current charges (transaction fees and margin interest, for example) may be deferred and added to the basis of the long-position side of the straddle.
- Tax treatment of married puts. It is possible that a married put will be treated as an adjustment in the basis of stock, rather than taxed separately. This rule applies only when puts are acquired on the same day as stock, and when the put either expires or becomes exercised. If you sell the puts prior to expiration, the result is treated as short-term capital gain or loss.
- Capital gains and qualification of covered calls. The most complicated of the special option-related tax rules involves the treatment of capital gains on stock. This occurs when you use covered calls. The federal tax laws have defined qualified covered calls for the purpose of defining how stock profits are treated; it is possible that a long-term capital gain could be converted to short term if an unqualified covered call is involved. The following section provides the details and examples of how qualification is determined.
By Michael C. Thomsett