Tax Treatment for Call and Put Options

Gains and losses on call and put options can be subject to capital gains tax or income tax. It depends on several factors, including how long you've held them in some cases. It's important to have a basic understanding of tax laws before you begin trading options because you'll almost certainly trigger taxes at some point.

Exercising Options

You might be subject to income tax or capital gains tax when you're exercising options depending on how long you've held them and some other factors. The taxable amount depends on which type of option you exercise.

Call Options

The premium paid for an option is included in the cost basis of the stock purchase when call options are exercised. Let's say a trader buys a call option for Company ABC with a $20 strike price and a June expiry. The trader buys the option for $1 or $100 total because each contract represents 100 shares. The stock trades at $22 upon expiry and the trader exercises the option. The cost basis for the entire purchase is $2,100. That's $20 x 100 shares plus the $100 premium, or $2,100.

Now let's say it's August and Company ABC is trading at $28 per share. The trader decides to sell their position. A taxable short-term capital gain of $700 is realized. That's $2,800 in proceeds minus the $2,100 cost basis or $700. Commissions can be included but there are none in this example.

The trader exercised the option in June and sold the position in August so the gains from the sale are considered a short-term capital gain. The investment was held for less than a year. But short puts and short calls are always treated as short-term gains or losses regardless of the holding period.

Put Options

Put options receive a similar treatment. The put's premium and commissions are added to the cost basis of the shares if a put is exercised and the buyer owns the underlying securities. This sum is then subtracted from the shares' selling price. The position's elapsed time runs from when the shares were initially purchased to when the put was exercised and the shares were sold.

Similar tax rules to a short sale apply if a put is exercised without prior ownership of the underlying stock. The period starts from the exercise date and ends with the closing or covering of the position.

Pure Options Plays

Both long and short options for the purposes of pure options positions receive similar tax treatments. Gains and losses are calculated when the positions are closed or when they expire unexercised. In the case of short call or put writes, all options that expire unexercised are considered short-term gains. Here are some examples that cover some basic scenarios.

Taylor purchases an October 2023 put option on 100 Company XYZ shares with a $50 strike in May 2023 for $3. They subsequently sell back the option when Company XYZ drops to $40 in September 2023 for $2 so they would have a short-term loss of $100 ( [ $3 x 100 shares ] - [ $2 x 100 shares ] ).

Taylor is eligible for a short-term capital loss of $100 ( [ $4 x 100 shares ] - [ $5 x 100 shares ] ) if they write a $60 strike call for 100 Company XYZ shares in May, receiving a premium of $4 with an October expiry, and decide to buy back their option in August when Company XYZ jumps to $70 on blowout earnings for $5.

Taylor will realize a long-term capital loss, however, on their unexercised option equal to the premium of $400 ($4 x 100 shares) if they purchased a $75 strike call for 100 Company XYZ shares for a $4 premium in May with an October expiry in the next year and the call is held until it expires unexercised. They owned the option for more than one year, making it a long-term loss for tax purposes and Taylor did not sell the option. It expired.

Covered Calls

Covered calls are slightly more complex than simply going long or short on a call. Someone who is already long on the underlying security will sell upside calls against that position with a covered call, generating premium income but also limiting upside potential. Taxing a covered call can fall under one of three scenarios for at- or out-of-the-money calls:

• Call is unexercised
• Call is exercised
• Call is bought back (bought-to-close)

Taylor owns 100 shares of Microsoft Corporation (MSFT) on Jan. 3, trading for $46.90. They write and sell a $50 strike-covered call with a September expiry, receiving a premium of $0.95:

• If the call goes unexercised and MSFT trades at $48 at expiration: Taylor will realize a short-term capital gain of $0.95 on their option even though the option was held for more than one year. They would treat the premium payment as a short-term capital gain realized on the expiration date regardless of the holding period when a short put or call option expires.
• If the call is exercised: Taylor will realize a capital gain based on their total position period and total cost. Taylor would realize a short-term capital gain of $13.95 ($50 - $37 + $0.95) if they bought shares in January for $37. This is the price at which they sold the stock minus the purchase price plus the call premium received. It would be short-term because the position was closed before one year.
• If the call is bought back: Taylor may be eligible for long- or short-term capital gains/losses depending on the price paid to buy the call back and the period elapsed in total for the trade.

The above example pertains strictly to at-the-money or out-of-the-money covered calls. Tax treatments for in-the-money (ITM) covered calls are vastly more intricate.

Qualified vs. Unqualified Treatment

The trader must first determine if the call is qualified or unqualified when writing ITM covered calls because the latter of the two can have negative tax consequences. A call will be taxed at the short-term rate even if the underlying shares have been held for over a year if a call is deemed to be unqualified.

Let's say that Taylor held shares of MSFT since January of last year at $36 per share and decided to write the June 5 $45 call, receiving a premium of $2.65. Because the closing price of the last trading day (May 22) was $46.90, one strike below would be $46.50, and the expiry is less than 30 days away, their covered call is unqualified. The holding period of their shares will be suspended.

Taylor will realize short-term capital gains on June 5, even though the holding period of their shares was over a year if their call is exercised and the shares are called away.

Protective Puts

Protective puts are a little more straightforward but not by much. The trader would qualify for long-term capital gains if they held shares of a stock for more than a year and wanted to protect their position with a protective put. The trading period would be immediately negated if the shares were held for less than a year and the trader purchases a protective put. Any gains upon the sale of the stock would be short-term gains.

The same is true if the underlying shares are purchased while holding the put option before the option's expiration date regardless of how long the put has been held before the share purchase.  

Wash Sale Rule

Losses on one security cannot be carried over to the purchase of another "substantially identical" security within 30 days, according to the IRS. This wash sale rule also applies to call options. 

Taylor would not be able to claim the loss if they took a loss on a stock and bought the call option of that very same stock within thirty days. Taylor's loss would instead be added to the premium of the call option and the holding period of the call would start from the date they sold the shares.

The cost basis of their new shares would include the call premium and the carryover loss from the shares upon exercising their call. The holding period of these new shares would begin at the call exercise date.

The loss from the first option would be disallowed and the loss would be added to the premium of the second option if Taylor were to take a loss on a call or put and buy a similar option of the same stock.

Straddles

Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. A trader would only be able to claim a $200 loss on the tax return for the current year if they were to enter a straddle position and dispose of the call at a $500 loss but have unrealized gains of $300 on the puts.

The Bottom Line

Taxes on options are incredibly complex. Options traders should build a strong familiarity with the rules governing these derivative instruments. This article is by no means a thorough presentation of the nuances governing option tax treatments and should only serve as a prompt for further research. A tax professional with investment and trading tax experience should also be consulted.

Correction - July 23, 2024: This article has been corrected to clarify that short puts and short calls are treated as short-term gains or losses regardless of the holding period.