Options can open up a whole new world of tax complexities, if consequences of certain actions are not understood in advance. The basics of reporting options trades are presented in this article, along with a lead-in to some of the more complex situations. Discussion of the IRS infamous "tax straddle rules" is deferred to the final article in the series.
Note that the commonly-used option terms in-the-money, at-the-money, and out-of-the-money will be abbreviated, respectively, as ITM, ATM, and OTM in the remainder of this article.
Straight-Forward One-Sided Equity Options - Exited via Closing Transaction or by Expiration.
The following discussion represents the simplest option cases, where one-sided calls or puts are traded, exercise / assignment does not occur, no stock positions exist in the stocks which are the underlying securities of the options traded, and no straddle rules apply to alter how the transactions are to be reported.
A gain or loss from a long call or put exited by selling the option prior to expiration is reported as a capital gain or loss in the year of sale, and is reported on Form 8949. The gain is short-term if the option was held for one year or less, or long-term if held longer than one year. If the option expired worthless, the expiration date is considered the date sold, and "EXPIRED" is specified in the sales price column.
A gain or loss from a short call or put exited by a closing transaction, whereby the option is purchased to close the position, is reported on Form 8949 in the year the closing transaction was executed, and the gain or loss is always short-term, regardless of how long the short option position was open. If the short option expired worthless, the expiration date is considered the date of the closing transaction, which in this case is the date acquired, "EXPIRED" is entered in the cost or other basis column, and again the gain is always short-term, regardless of how long the short option position was open.
Impacts of Options Exercise on Stock Basis / Amount Realized
If a call is exercised, the call buyer, who has acquired the stock through assignment, has a basis in the stock consisting of the cost of the stock, as per the exercise price, plus the stock purchase commission, plus the cost of the call option and the related option purchase commission. The holding period of the stock thus acquired begins on the day after exercise. The call seller must add the option premium received, net of the option sales commission, to the proceeds from the stock sale, when computing the gain or loss on the stock. The gain or loss will be short-term or long-term, depending upon how long the stock was held, considering the date the option was exercised as the sale date. Note that this assumes the stock holding period is not impacted by the tax straddle rules, which will be the case as long as the call sold was a "qualified" covered call which was OTM. This would be the case for an OTM call which when sold had at least 30 days to go to expiration.
If a put is exercised, the put buyer, who has sold the stock through exercise of the put, reduces the amount realized on the sale of the stock by the cost of the put, including the put purchase commission. If the stock had not been held long-term prior to the put purchase, the stock holding period is affected. See the next paragraph for more detail on this. All of the preceding assumes the put as originally purchased was not ITM. If it was ITM, the long stock and long put may be a compound position subject to the tax straddle rules, to be discussed subsequently. The put seller, who has purchased stock from assignment of the put, must reduce the cost-basis of the stock position by the net proceeds received from writing the put, which would be the premium received less the put sales commission.
Put Option as Short Sale - Impact on Stock Holding Period
Buying a put to protect a long stock position is treated as a short sale by the IRS, and the stock holding period can be affected. If the stock had been held for one year or less at the time of the put purchase, or if the stock was acquired after the put purchase, any gain on the put, whether by exercise, expiration, or sale, is short-term capital gain regardless of how long the put position was open. The holding period of the stock position is also affected, and is considered to begin anew upon the earliest of:
· The date the stock was sold, independent of the put, while the put position is still open. The stock is considered held only one day in this case, just as when closing a short position by purchase of new shares.
· The date exercise of the put occurs. Again, the stock is considered held only one day, just as when closing a short position by purchase of new shares.
· The date the put was sold. The stock position is retained, holding period resets.
· The date the put expires, worthless. The stock position is retained, holding period resets.
Thus, a long put basically causes a reset of the holding period of the stock position being protected by the put, unless the stock was already a long-term holding prior to the purchase of the put.
These rules are per IRS Publication 550, page 61, under the heading Put Option as Short Sale.
The simultaneous purchase of stock and a protective put, referred to as a "married put", is exempted from the holding period adjustment as discussed, as far as consideration of the put as a short sale is concerned. But, in the tax straddle rules, no such exemption exists. This underscores that much has been left unclear by the IRS regarding this entire area, and different sections of the IRS rules are sometimes inconsistent. See the resource entitled Tax Notes Special Report listed under Resources and Disclaimer below for an interesting discussion by some renowned authorities on the tax straddle rules as they presently exist.
Wash Sale Rules and Options
Wash sale rules also apply to options, similarly to stocks. In addition to losses on options being disallowed due to re-entry of options positions during the 61 day wash sale period, options can also cause stock positions sold to be impacted by the wash sale rules. For example, if an investor had a loss on a stock sale, but sold an ITM money put on the stock within the 61 day wash sale period, and there is a "substantial likelihood" that the put will be exercised, the loss on the stock is disallowed, because it is considered a wash sale due to the put sale.
Reporting Non-Equity Index Options on Broad-Based Stock Indexes
The special case presented by trading index options needs to be discussed at this point. Unlike equity options, a cash-settled option on a broad-based stock index, which is defined by the IRS as one containing more than nine components, plus some additional qualifications, is to be treated as a "Section 1256 Contract", and is to be reported under mark-to-market (MTM) rules applicable to these types of contracts. Under the Section 1256 MTM rules, any open positions at year-end are to be reported as sold based on the year-end closing prices. The result is then factored into the cost-basis of the positions going forward, such that when the positions are disposed of, the correct gain or loss is computed. Further, per Section 1256 rules, the gain or loss is to be treated as 60% long-term and 40% short-term, regardless of how long the positions were held. MTM results on open index option positions at year-end, or for that matter closed trades as well on them, are to be reported on Form 6781, which feeds into Schedule D in a similar fashion as Form 8949. A couple of broad-based index examples are the S & P 500 Index (SPX) and the S & P 100 Index (OEX). Note that options on commodity ETFs, such as GLD and SLV, also fall under this rule. Options on stock ETFs, even those which track broad-based indexes, such as DIA or SPY, do not fall under the Section 1256 rule, in the opinion of some experts, although others disagree.
At any rate, complications can be avoided by not carrying any open index option positions across a year boundary. In fact, to avoid having to deal with Form 6781, these types of options might be better avoided entirely.
Resources and Disclaimer
All of the preceding is based on my review of the following resources:
J.K. Lasser's Your Income Tax for 2013, available from bookstores everywhere.
Various IRS Publication, particularly the 1040 Instruction booklet, plus instructions for Schedules A, B, C, D, and E, and Publication 550, Investment Income and Expenses. A link to the IRS website is provided here.
Tax Notes Special Report - Examining the Straddle Rules After 25 Years. This report is very interesting as a distinguished list of practitioners comment on the Tax Straddle Rules. A link is provided here.
Tax Consequences Associated With Option Strategies, a series of articles provided by BBD, LLP, a Certified Public Accounting firm located in Philadelphia, PA. Links to Part I, Part II, Part III, and Part IV are hereby provided.
Qualified and Unqualified Covered Calls, by Michael Thomsett. Mr. Thomsett is the author of a book entitled Options Trading for the Conservative Investor, which is listed as recommended reading at my own website. Recommended reads are listed under Approach, Resources and Account Management.
Covered Calls and Options - You Make The Call, available from The Motley Fool. The link is to a brief treatise authored by "zman49".
I want to note that I do not necessarily concur with all of these resources, and the deeper I go into the topic, the more I notice that even experts occasionally differ from each other as well on various points. All I can suggest is to research as much as possible, and go with what seems to be the correct stance. That is what I have tried to do in this article series.
While I have made a good faith effort to understand and present the topics discussed in this article, relying upon the resources cited, I want to reiterate that I am not a financial professional, nor am I certified in any way as a financial advisor or tax expert. I am an independent, individual investor, focusing on dividend-paying stocks exclusively. I am always seeking to become more knowledgeable on investments and related topics, and on sharing what I have learned with other investors in similar circumstances. Also, I want to reiterate a caution mentioned in the first paragraph of Part I and in the Disclaimer section of all succeeding articles, which is that the points I am bringing out are limited to commonly occurring situations that investors in publicly traded stocks and options experience, with positions held "in street name" in brokerage accounts. Readers need to realize that the information as presented is not all-inclusive, and that there are many exception conditions and special cases that are not discussed.
Investors are advised to seek professional tax advice and assistance in handling their own tax situation. However, becoming a knowledgeable and conversant client on tax issues affecting investors will save time and money, and will improve the likelihood of correct tax filings.
The next article will conclude this somewhat ambitious series, as I attempt a coherent presentation of the IRS Tax Straddle Rules, with emphasis on writing covered calls, in Part VI.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.