Successful investing in options can generate both income and capital gains. Once you’ve made a profitable trade, it becomes important to know the rules regarding the tax treatment of your earnings.
Understanding IRS rules allows for nuanced tweaking of positions to legally lower your tax bills in a number of ways.
Here are a few basic principles on this topic. I’ll explain each of these items in detail later on.
Things to Know About the Taxation of Options
- Options are never taxed when they are initiated (bought or sold to open). They become taxable events only after they expire or are closed out.
- Expired options show taxable profits or losses in the tax year when they expire.
- Exercised options are not taxable as separate transactions. Premiums collected or paid when the options were opened go towards adjusted sales or purchases prices on the underlying shares.
- Purchased long-term options (LEAPS) can qualify for long-term capital gains tax rates if held for more than one year and then sold to close.
- Short sales of options can never qualify for long-term capital gains rates if they expire or are closed for profits, even if more than one year has elapsed from opening to closing.
So why aren’t options taxed when initiated?
Well, as with stocks, bonds and ETFs, you can’t know in advance if an option trade will end up with a gain or loss. You can only be sure of that after the trade is done.
That works to option sellers’ favor. They collect premium dollars up front because they sell to open (STO), with the money being put in their accounts on the next business day following the trade.
And selling an option in 2021 which expires in 2022 or later defers all tax consequences on that income until the year after the option trade is closed. So selling 2023 LEAP options means potentially deferring taxable gains until filing your 2023 Schedule D in April of 2024.
Every option that expires worthless automatically becomes a taxable event based on the year that it occurs. Losses on options purchased, which later had no value, or gains on options sold which never had to be bought back, are reportable on the following year’s Schedule D.
Exercised options are treated differently than expired ones. Here are some examples of what I’m speaking about:
Suppose you’d bought an AAPL Jan. 2021 $120 Call for $5 per share back when Apple (AAPL) sold for much cheaper. If you later exercised your call option to take delivery of 100 shares, your cost basis would become $125 per share ($120 strike price + $5 call premium paid) plus any option exercise fees.
There is no taxable event, though, until you later sell your 100 AAPL shares. That would be true even if AAPL had been $150 at the time of exercise. The paper profit of $25/share would simply be reflected on your brokerage statement.
The holding period for your AAPL position would start on the date of exercise, just as if you’d purchased on the open market. If held for over one year from that time, the ultimate gain or loss from the adjusted price paid would qualify for long-term tax treatment.
If a put that was sold short later becomes exercised, the premium per share received would not be taxable yet. It would go towards lowering your adjusted cost basis. So if you’d sold a Microsoft (MSFT) $230 put for $20 per share and were forced to buy, your new basis would be $210 ($230 strike price minus the $20 put premium).
Any gain or loss upon MSFT’s ultimate sale would reflect the option premium as part of the stock trade, not as a separate taxable transaction.
Money spent on a put purchased as “term insurance” against a price decline would likewise be folded into the profit or loss calculation if actually exercised. So a MSFT $230 put which cost $10 would show as a sale at a net price of just $220 for tax purposes.
That same put, if it is never exercised, would show as a $1,000 loss ($10 per share x 100 shares) on your tax return. Because it was owned, rather than shorted, it would end up being a short-term loss (the most valuable for tax savings) if held less than one year before expiring.
So why can’t short sales of puts or calls ever attain long-term tax treatment, even if the positions extend for more than one year?
The answer is simple. Long-term treatment requires at least a 366-day holding period. Short sales of options, stocks or ETFs offer no holding periods as you never actually own the underlying asset. And no holding period means no long-term gain or loss is possible.
How to Minimize Taxes on Options
Now that I’ve covered the basic rules, let me give you a few tips on minimizing taxes and/or deferring gains out to future tax years.
You own 1000 MIK at $5 per share but later sold 10 Mar. 19, 2021 $17.50 covered calls (covered calls are simply out-of-the-money calls against a long position, with one call for every 100 shares) on Michael’s (MIK) for $1.50 per share when the stock was selling for about $14. You’re already long-term on the stock.
Here is what the shares and that option were priced at on Mar. 3, 2021 after MIK accepted a $22 all-cash buyout bid.
If you do nothing and simply let the covered calls get exercised, the net sales price will be $19 per share ($17.50 strike price + $1.50 in call premium).
Your net profit would be $19,000 - $5,000 = $14,000, taxed at your long-term capital gains rate. Paying 15% on a $14,000 net gain per 100 shares would be a $2,100 tax bite.
But why not unwind your position by buying back those call options for $4,500 ($4.50 x 1000), taking a short-term loss of $3,000? That $3,000 loss reduces your tax bite at your highest marginal rate. In a 28% bracket, you’d save $840 in short-term taxes.
Meanwhile, tendering, or simply selling the shares at $22 will result in a larger long-term gain of $17,000 ($22,000 less the $5,000 original cost basis).
$17,000 taxed at 15% produces a $2,550 tax hit at the capital gains rate, less the $840 loss on the call buyback. The net total tax due would be $1,710 versus $2,100.
Therefore, unwinding the call prior to exercise would save $390 per each 1000 shares, versus getting called away.
The total dollars collected would be essentially identical, but you just turned a less-than-optimal covered call sale into some nifty tax savings.
The same process could be done in reverse if a poorly-timed put sale left you with an underwater put which is likely to be exercised.
Unwind the trade by buying to close out the put. That triggers a short-term loss at your highest marginal rate which will reduce your Schedule D tax bill. You could then buy the stock, if you still like it to rebound, and start the clock ticking on making a long-term gain as it rebounds.
In this case the loss would become realized, while any future gain will be deferred until a later time.
Investors are required to pay taxes on gains made, but there’s no law that says you can’t minimize the taxes owed through shrewd techniques like these.
Disclosure: Paul has been successfully trading options for more than 40 years. At the time of this article, Paul had no positions in AAPL or MSFT, and was long shares and short options on MIK.