How Options Are Taxed

Options trading has exploded in popularity in recent years, offering flexibility, diversification, and the potential for extremely high returns, but the tax implications are often complex and can directly impact your profits. 

Whether you're a seasoned trader or new to the world of options, understanding how taxes affect your trades is essential.

Who Does the IRS Consider a Trader?

The IRS differentiates between "investors" and "traders," which can significantly impact how your trades are taxed. 

To qualify as a trader, options trading must be your primary business activity, and your income must primarily come from trading. 

Because of this, most people fall into the "investor" tax category, even if they trade actively. 

If you are in that majority of day traders, you will be subject to capital gains taxes, while those that are purely traders might qualify for different rules and deductions.

Types of Options and Their Tax Implications

The taxation of options depends on several factors, including the type of option, your holding period, and whether you are buying or selling the contract.

Generally speaking, options fall into two categories: equity options and non-equity options. There are also employee stock options, but we will only focus on the former two today, as they pertain to active traders.

Equity Options

Equity options are tied to ETFs and individual stocks, and are taxed based on the type of position (long or short), and the holding period. These are the two crucial factors to consider for understanding the tax implication of trading equity options.

For long positions (buying call or put options), your tax treatment will primarily depend on how long you hold the contract. If you sell or exercise the option within a year, any profits you make will be taxed as short-term capital gains. The same applies for any incurred losses, which will also be classified as short-term.

If you hold options for more than a year, you will be taxed at a more favorable long-term capital gains rate, but losses will as well, which can offset other long-term gains. 

When you exercise a long option, the premium you pay will be factored into the cost basis of the underlying asset. Because of this, taxes will be due only when the asset is sold, and the holding period of the asset is what determines whether your gains will be classified as short or long-term.

For short positions (writing calls or puts), your taxation will be treated differently due to the immediate taxable event created by the premium you received.

All the premiums you collect when writing an option are taxed as short-term capital gains, regardless of how long you kept the position open. This rule will apply whether you exercise or close the option, and even if it expires worthless. You must report the entire premium during the tax year in which the option expires.

When a written call is exercised, the premium will be added to the stock’s sale proceeds, and the holding period of the stock is what will determine the tax rate on any gains. For written puts, the premium after exercising them reduces the cost basis of the purchased stock, and taxes will apply when the stock is eventually sold.

Non-Equity Options

The second main type of taxable options are non-equity options, which are tied to assets like commodities, indices or currencies, and they differ significantly in terms of tax treatment. These contracts often fall under Section 1256 of the Internal Revenue Code, which offers favorable tax rules for active traders.

The primary benefit of non-equity options that are classified as Section 1256 contracts is called the 60/40 rule. This rule dictates that 60% of any gains you make will be taxed as long-term capital gains, while the remaining 40% are taxed as short-term gains, regardless of how long you held the contract. 

This tax treatment can be positive in reducing the overall tax burden, especially for those traders who buy and sell non-equity options more frequently.

Another unique aspect of non-equity options is called the mark-to-market rule, which requires you as a trader to recognize gains or losses at the end of each calendar year, as if you sold the positions at their fair market value on December 31. 

These unrealized gains or losses will be reported on your tax return for that year, and will reset the cost basis for the following tax period. The mark-to-market rule simplifies record-keeping, reduces the risk of deferred tax liabilities and ensures that all positions are accounted for annually.

Taxation of Complex Equity Option Strategies

Most options traders use a variety of trading platforms and complex trading strategies such as spreads, straddles, butterflies and stranges to hedge risks and increase returns, but the IRS once again has a different classification for these when it comes to active traders, often classifying and grouping them under the term “straddle”. 

For tax purposes, the IRS states that a straddle occurs when one position significantly offsets or reduces the risk of loss for another position, like if for example you own a stock and purchase a put option to hedge against a price drop. In such cases, unique tax rules will apply to prevent you from realizing losses prematurely.

Any losses on what the IRS will classify as a straddle will be deferred, so if you close one side of a straddle while the other remains open, the losses on the first side will be deferred until the offsetting position is closed. However, if the loss exceeds the unrealized gain on the offsetting position, the excess loss may be tax deductible.

Qualified Covered Calls (QCCs) are the exception from straddle rules, but only if they meet certain criteria, such as having an expiration date which is more than 30 days away, and a strike price that is not “deep in the money”. These qualified covered calls allow for immediate loss recognition, which in turn simplifies tax treatment.

If the call does not meet QCC requirements, it is treated as part of a straddle. Losses on the call may be deferred if the underlying stock shows an unrealized gain.

Wash Sale Rule and Its Application to Options Trading

The wash sale rule applies to options trading, preventing you from selling an option at a loss and repurchasing the “substantially identical” option or underlying security within the 30-day window.

The IRS defines “substantially identical” broadly, covering scenarios where options replicate exposure to the same underlying asset. For example, if you sell a call option at a loss and buy another call with a similar expiration date and strike price, you can trigger the wash sale rule.

When the rule applies, the loss from the initial sales is disallowed and added to the cost basis of the new position, which effectively defers the tax benefit until the new position is sold.

Additionally, the original position’s holding period transfers to the new one, further impacting whether subsequent gains or losses are taxed short-term and long-term. 

The wash sale rule can complicate your tax planning, so accurate record-keeping becomes critical in identifying potential wash sales and adjusting the cost basis of affected positions. We advise that you use the help of a tax professional or use specialized tax software to ensure compliance and optimize your tax strategy.

Bottom Line

As you can see, options trading comes with plenty of tax implications, both for equity and non-equity options. It is therefore crucial to learn all the rules and keep detailed records to ensure compliance with the IRS regulations.