Beverly Goodman

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This Tax Season, Know Your Options

Beverly Goodman

Trading in options can be tricky, but the tax consequences of those trades can be even trickier.

Options are contracts that give the holder the right to buy or sell a specified number of shares of the underlying stock at a specified price per share (the strike price) by a specified date (the option expiration or exercise date). Call options grant the holder the right to buy shares; put options guarantee you the right to sell shares.

In short, if you buy a call option you're betting the underlying shares will increase in price by the exercise date. If they do, you exercise your options and buy the shares at the specified (lower) price. If they don't, you let the options expire and all you've lost is the premium, or what you paid for the options contract.

Put options essentially work the same way in reverse: If you buy a put option, you're betting the underlying shares will decrease in value by the exercise date. If they do, you exercise your options and sell the underlying shares at the specified (higher) price. If they don't, you let the options expire and all you've lost is the price of the options contract.

Like the underlying stocks themselves, option pricing depends on a variety of factors. These include supply and demand, the length of the option period (the farther off the expiration date, the less risky the option, so the premium for the options contract will be higher) and the volatility of the underlying stock (the more volatile the stock, the riskier the option contract and the more expensive it will be).

Puts and calls can be used to make bets on stock price movements, or as a way of protecting paper profits. (For more on options strategy, see Cut Your Risk With Call Options or check out TheStreet.com's In the Money Options Coverage.)

Option Buyers

The option purchaser, or holder, has three, er, options regarding what to do with his or her options: exercise the option, allow it to expire, or sell the option contract itself. Not surprisingly, each decision spurs a different tax consequence.

Exercising your options. When you exercise an option and buy or sell the underlying stock, your basis in the underlying shares is adjusted by the amount of the premium you paid for the options. For instance, if you exercise a call and buy the stock, there's no immediate taxable event. You simply add the cost of the call (the premium) to the basis of the stock. The higher basis means you'll pay less in capital gains tax when you eventually sell the stock (assuming you do so at a higher price; otherwise you'll just incur a greater loss).

If you exercise a put and sell your stock (assuming you already have the stock in your portfolio), the cost of the put reduces the gain realized when you sell the underlying stock -- again, resulting in less of a capital gain.

Allowing the options to expire. If you allow the option to expire without exercise, you incur a capital loss. The loss can be either a short-term or long-term loss, depending on the holding period of the option. The clock starts on the day you purchase the option contract, and the holding period ends on the contract's expiration date.

Selling your options. The same tax treatment applies to when you sell an option. You'll realize a short-term or long-term capital gain or loss, depending on how long you've held the option.

Option Sellers

Writing (selling) options does not trigger an immediate taxable event. That means the premium received for writing the option does not count as income at the time of receipt -- you'll only realize a profit or loss when the transaction is closed. The transaction is considered closed when the holder either exercises the option or lets it expire.

Additionally, the transaction will be considered closed if you make what's called a closing purchase, or "buy in" new options that essentially washes out the first set. In such a transaction, the writer buys an identical option -- only the premium is different -- which offsets the first contract. In such cases, you'll realize profit or loss for the difference between the premium of the option you sold and the cost of the closing option contract.

Exercised options. If the option is exercised, add the premium to the sales proceeds of the stock to determine gain or loss on the sale of the stock. Whether the gain or loss is short-term or long-term depends on the holding period of the stock.

Expired options. If the holder doesn't exercise the option before the expiration date, simply report the premium you collected as a short-term capital gain in the year the option expires.

Wash Sale Rule

You didn't think we'd get through a story on investing and taxes without some mention of the wash sale rule, did you? This rule disallows any deduction on a loss from the sale of a security if the identical security was purchased within 30 days before or after the sale date. The rule also includes options held that would enable you to acquire the identical security.

A loss on a covered call (one in which the taxpayer writes a call option for stock that's already in his or her own portfolio) that has a strike price below the current stock price might be considered a long-term capital loss. If selling the stock would have resulted in a long-term gain at the time the option was exercised by the holder (causing the loss on the option), you're allowed to claim a long-term loss.

The holding period of the underlying stock, though, doesn't include the time it was hedged. So you'll have to subtract from the holding period the length of the option contract.

And the Internal Revenue Service's parting shot on the matter -- year-end losses from covered call options are not deductible unless the stock is held uncovered for more than 30 days after the date on which the option is closed.