Options Tax Considerations
Before you invest in options, get familiar with this required reading: Characteristics and Risks of Standardized Options. And then, work to understand the tax consequences (which is why you're here).
Your profit when you sell an investment for more than you paid for it is known as a capital gain. Those gains are taxable in the year you receive them unless you've held the investment in a tax-deferred or tax-free account. That's true for gains on options as well as those on stocks, mutual funds, ETFs, and most other investments. The rate at which your capital gains are taxed depends both on how long you owned the investment before selling and your marginal tax rate. That's the rate you pay on your last dollar of income.
Long-term capital gains are those on investments you've held for longer than a year, and they are taxed at a lower rate. For tax year 2013 and following years, taxpayers in the 10% or 15% tax bracket face no tax on their long-term gains. For those in the 25%, 28%, 33%, and 35% brackets, it's 15%. For those in the 39.6% bracket, it's 20%.
If you buy and sell an investment within a year, you have a short-term gain. Those gains are taxed at the same rate as your ordinary income. Most options transactions fall into the short-term category.
The good news, though, is that any capital gains tax you owe is based on your overall gains for the year. So if you make a profit on one short-term investment, but lose money on another short-term investment, you can use that capital loss to offset all or part of your capital gain. This reduces your tax obligation. The same is true for long-term gains and losses. In addition, the premiums and transaction costs of trading options are factored in to your gain or loss.
What's the Term?
For stocks, calculating whether you've held an asset for more than a year or less than a year is a simple matter of looking at the purchase date and the sales date. That's true as well if you buy options contracts. If an option you've bought expires or if you sell it, the period during which you held the option determines whether your gain or loss is short term or long term.
When you sell options contracts, whether you report a short or long term gain depends on how you close out your position. If your option isn't exercised before expiration, the premium you received for selling is always treated as a short-term gain. This premium is taxable in the calendar year the option expires. That may not be the year you received the premium. So you may have an extra year to pay whatever tax is due.
If you close out your short position, your gain or loss is also short term. But if you're assigned to buy or sell the underlying because an option you sold is exercised, whether the gain or loss is long term or short term depends on a number of factors. You should consult your tax adviser if you are in this situation.
Keep Good Records
Good records are essential anytime taxes are involved. It's smart to keep records of all the options positions you open and close during a tax year. That includes all trade confirmations and documentation of premiums paid and received, transaction costs, the dates you opened each position, when and how it was closed, and the gain or loss it provided.
It's a good idea to keep account statements you receive from your brokerage firm. They will include the cost basis of each transaction, which you can use to figure gains and losses. You'll also receive an IRS Form 1099 from your brokerage firms reporting your gains and losses for the tax year.
The Forms to Use
All options transactions must be reported to the IRS by attaching the appropriate forms when you file your tax return for the year.
Schedule D. The form on which you tally your capital gains and losses, both short term and long term
Form 6781. The form on which you report gains or losses on straddles, options that are subject to the 60/40 rule, or the mark to market requirement The IRS suggests you hold onto these documents and supporting material for three years after you file. That's the normal time limit for auditing your return.
Working With a Tax Adviser
If you trade options, it's always wise to work with an experienced tax adviser both when filing your tax return and when you're considering opening or closing options positions. Since exercising an option often involves a transfer of stock, options have tax consequences for your overall financial situation. While you don't want to make investment decisions based only on their tax implications, neither do you want to ignore the impact taxes can have on your bottom line.
Further, a tax adviser can help you understand the IRS rules as they apply to your options positions and will be able to explain the often complex rules that apply to certain options strategies.