Tax Treatment for Call and Put Options

Gains and losses on puts and calls can be treated as capital gains or income tax, depending on the scenario, how long you've held them, and the exact circumstances. It is crucial to build a basic understanding of tax laws before you begin trading options because, at some point, you'll trigger taxes.

Exercising Options

When you're exercising options, you might be subject to income or capital gains tax, depending on how long you've held them. The taxable amount depends on which type of option you exercise.

Call Options

When call options are exercised, the premium paid for the option is included in the cost basis of the stock purchase. For example, a trader buys a call option for Company ABC with a $20 strike price and a June expiry. The trader buys the option for $1, or $100 total, as each contract represents 100 shares. The stock trades at $22 upon expiry, and the trader exercises the option. The cost basis for the entire purchase is $2,100. That's $20 x 100 shares, plus the $100 premium, or $2,100.

Let's say it is August, and Company ABC now trades at $28 per share. The trader decides to sell their position. A taxable short-term capital gain of $700 is realized. That's $2,800 in proceeds minus the $2,100 cost basis, or $700 (commissions can be included, but in this example, there are none).

Because the trader exercised the option in June and sold the position in August, the gains from the sale are considered a short-term capital gain, as the investment was held for less than a year.

Put Options

Put options receive a similar treatment. If a put is exercised and the buyer owns the underlying securities, the put's premium and commissions are added to the cost basis of the shares. This sum is then subtracted from the shares' selling price. The position's elapsed time begins from when the shares were originally purchased to when the put was exercised (i.e., when the shares were sold).

If a put is exercised without prior ownership of the underlying stock, similar tax rules to a short sale apply. The period starts from the exercise date and ends with the closing or covering of the position.

Pure Options Plays

Both long and short options for the purposes of pure options positions receive similar tax treatments. Gains and losses are calculated when the positions are closed or when they expire unexercised. In the case of call or put writes, all options that expire unexercised are considered short-term gains. Below is an example that covers some basic scenarios.

Taylor purchases an October 2023 put option on 100 Company XYZ shares with a $50 strike in May 2023 for $3. If they subsequently sell back the option when Company XYZ drops to $40 in September 2023, they would be taxed on short-term capital gains (May to September) or $10 minus the put's premium and associated commissions. In this case, Taylor would be taxed on a $700 short-term capital gain ($50 - $40 strike - $3 premium paid x 100 shares).

If Taylor writes a $60 strike call for 100 Company XYZ shares in May, receiving a premium of $4 with an October expiry, and decides to buy back their option in August when Company XYZ jumps to $70 on blowout earnings, then they are eligible for a short-term capital loss of $600 ($70 - $60 strike - $4 premium received x 100 shares).

If, however, Taylor purchased a $75 strike call for 100 Company XYZ shares for a $4 premium in May with an October expiry in the next year, and the call is held until it expires unexercised (say Company XYZ traded at $72 at expiry), Taylor will realize a long-term capital loss on their unexercised option equal to the premium of $400 ($4 x 100 shares). This is because they would have owned the option for more than one year, making it a long-term loss for tax purposes.

Covered Calls

Covered calls are slightly more complex than simply going long or short a call. With a covered call, somebody who is already long the underlying security will sell upside calls against that position, generating premium income but also limiting upside potential. Taxing a covered call can fall under one of three scenarios for at- or out-of-the-money calls:

• Call is unexercised
• Call is exercised
• Call is bought back (bought-to-close)

For example, on Jan. 3, Taylor owns 100 shares of Microsoft Corporation (MSFT), trading at $46.90, and writes a $50 strike covered call with a September expiry, receiving a premium of $0.95:

• If the call goes unexercised and MSFT trades at $48 at expiration: Taylor will realize a short-term capital gain of $0.95 on their option, even though the option was held for more than one year. When a put or call option expires, you treat the premium payment as a short-term capital gain realized on the expiration date, regardless of the holding period.
• If the call is exercised: Taylor will realize a capital gain based on their total position period and total cost. So if they bought shares in January for $37, Taylor would realize a short-term capital gain of $13.95 ($50 - $36.05 or the price they paid minus the call premium received). It would be short-term because the position was closed prior to one year.
• If the call is bought back: Depending on the price paid to buy the call back and the period elapsed in total for the trade, Taylor may be eligible for long- or short-term capital gains/losses.

The above example pertains strictly to at-the-money or out-of-the-money covered calls. Tax treatments for in-the-money (ITM) covered calls are vastly more intricate.

Qualified vs. Unqualified Treatment

When writing ITM covered calls, the trader must first determine if the call is qualified or unqualified, as the latter of the two can have negative tax consequences. If a call is deemed unqualified, it will be taxed at the short-term rate, even if the underlying shares have been held for over a year. The guidelines regarding qualifications can be intricate, but the key is to ensure that the call is not lower by more than one strike price below the prior day's closing price and the call has a period of longer than 30 days until expiry.

For example, Taylor has held shares of MSFT since January of last year at $36 per share and decided to write the June 5 $45 call, receiving a premium of $2.65. Because the closing price of the last trading day (May 22) was $46.90, one strike below would be $46.50, and since the expiry is less than 30 days away, their covered call is unqualified, and the holding period of their shares will be suspended. If, on June 5, the call is exercised and Taylor's shares are called away, Taylor will realize short-term capital gains, even though the holding period of their shares was over a year.

Protective Puts

Protective puts are a little more straightforward, but not by much. If a trader has held shares of a stock for more than a year and wants to protect their position with a protective put, the trader will still be qualified for long-term capital gains. If the shares have been held for less than a year (say eleven months) and the trader purchases a protective put, even with more than a month of expiry left, the trader's holding period will immediately be negated. Any gains upon the sale of the stock will be short-term gains.

The same is true if shares of the underlying are purchased while holding the put option before the option's expiration date—regardless of how long the put has been held prior to the share purchase.  

Wash Sale Rule

According to the IRS, losses of one security cannot be carried over towards the purchase of another "substantially identical" security within a 30-day time span. The wash sale rule applies to call options as well. 

For example, if Taylor takes a loss on a stock and buys the call option of that very same stock within thirty days, they will not be able to claim the loss. Instead, Taylor's loss will be added to the premium of the call option, and the holding period of the call will start from the date that they sold the shares.

Upon exercising their call, the cost basis of their new shares will include the call premium and the carryover loss from the shares. The holding period of these new shares will begin upon the call exercise date.

Similarly, if Taylor were to take a loss on an option (call or put) and buy a similar option of the same stock, the loss from the first option would be disallowed, and the loss would be added to the premium of the second option.

Straddles

Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. If a trader were to enter a straddle position and dispose of the call at a $500 loss but has unrealized gains of $300 on the puts, they will only be able to claim a $200 loss on the tax return for the current year.

The Bottom Line

Taxes on options are incredibly complex, but it is imperative that options traders build a strong familiarity with the rules governing these derivative instruments. This article is by no means a thorough presentation of the nuances governing option tax treatments and should only serve as a prompt for further research. A tax professional with investment and trading tax experience should also be consulted.