This Tax Season, Know Your Options

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.