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Equity Options (Calls & Puts)
As its name suggests, an investment option is essentially a contract that gives the buyer of the contract the right to take some type of action should they choose to do so. The buyer of calls/puts pays a premium to purchase the contract. After the purchase of the contract, the contract can either expire, or the buyer can choose to exercise the contract.
Let's review each of these possible scenarios, and their tax treatments.
Call/Put Option Expires
If the call/put option expires without being exercised, the premium paid becomes a capital loss. If the contract was held for less than one year it is considered a short-term loss, or a long-term loss if held for one year or longer.
Call Option Exercised
If the buyer chooses to exercise the call option, the original premium paid for the options is added to the cost basis, or original cost of the underlying stock that is purchased. Once the stock is sold, the investor will incur a capital loss or gain. The capital loss/gain would be either short term or long term depending on the holding period.
Put Option Exercised
The tax treatment of an exercised put is very similar to that of a call. The main difference is the buyer of the contract may already own the underlying stock. Once the put is exercised the buyer can sell the stock position at the strike price.
Additional Equity Options
Let's now consider additional types of equity option contracts and the related tax treatments.
Covered calls are call option contracts in which the writer or seller of the contract owns the underlying stock.
The tax treatments are:
- Call expires - Writer would realize a short-term/long-term capital gain of the premium paid.
- Call is exercised - Writer would factor premium received into cost basis, and would incur a short-term/long-term capital gain/loss (strike price minus cost basis) when the underlying stock is sold.
- Call purchased back by writer - Writer would incur short-term or long-term capital gain based on original premium received and the price paid to repurchase contract (re-purchase price minus premium received).
Wash sales, which are prohibited by the IRS, occur when one position is sold at a loss and another identical position is purchased within 30 days. The loss from the original sales cannot be carried over to the purchase of the new shares. This rule applies to both call and put options.
Loss cannot be claimed for original shares sold, and would be carried over to cost basis of new shares purchased. The holding period would start from the date original shares were sold.
Protective puts are puts purchased by an investor who already owns the underlying position. As the name suggests, the purpose is to protect the original position. The IRS allows protected puts if the underlying position has been held for one year or longer.
The tax treatments are:
- Stock Position held <1 year - The time period that they've held the stock position is forfeited. Once the position is liquidated, any gains would automatically be classified as short-term gains. The same rule applies if an investor who holds a put position purchases the underlying stock before the put expires.
- Stock Position held >1 year - The premium for the put would be added to the cost basis of the stock and would be eligible for long-term capital gain treatment.
Straddle position is created when an investor purchases a call and put option for the same stock position. The strike price and expiration date for both options are also the same.
Tax losses on straddles are reduced by any gains received on the opposite position.
Index options are categorized based on the underlying index on which the option is based. The types of index options are those based on equity indexes, exchange traded indexes, and listed options on indexes. Each of these index options has a specific tax treatment.
- Listed index options are those listed on broad-based indexes or narrow-based indexes. For broad-based options, profits are realized as 60% long-term capital gains and 40% short-term capital gains. Narrow-based options receive either short-term or long-term capital gain treatment based on the holding period.
- Equity index options receive regular tax treatment based on the investor's tax bracket.
- Exchange-traded index options receive either 100% short-term or 100% long-term capital gain based on the holding period.
According to the IRS, a Section 1256 contract includes foreign currency contracts, yield-based options, non-equity, dealers equities, regulated futures, and dealers securities futures.
Foreign currency gives the buyer the right to exchange money from one currency into another currency at the contract exchange rate. These options fall under Section 988 of IRS code, but can also qualify as Section 1256 contracts.
Yield-based options are bought and sold based upon underlying debt instruments. The value of a yield-based option is derived from the difference between the option's exercise price (expressed as a percentage) and the yield of the debt security. These options are classified as Section 1256 contracts.
Section 1256 contracts, if held until year-end, can be treated as if they were sold at fair market value. Any associated gains or losses are treated as either short-term or long-term capital gains depending on the holding period.
An option is a contract that can have specific tax consequences depending on the type and the action that is taken or not taken. We have discussed the different types of options contracts, including equity, index, foreign currency, and yield-based options, and their specific tax treatments. In addition, we discussed options transactions that can become a tax liability for investors, including wash sales, covered calls, and protective puts.
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