Put and call options are a valuable source of income for many investors and traders, but taxation of that income isn't as straightforward as it is with more standard stock and bond investments. Tax reporting and calculation depend on whether you buy the option contract or sell it and what happens after that initial trade is made.
Option Trading Process
To clarify, an option contract offers the holder the right to buy or sell a particular security for a given "strike" price. If the holder has a right to buy, the option is a call, while the right to sell is known as a put. Options are offered by "writers" -- traders who are obligated to honor the options contract if it is exercised. The money exchanged for the purchase of the options contract is its premium. You do not need to do any tax reporting on the option premium until the contract is exercised, sold or expires. Report options-related transactions on Internal Revenue Service Form 8949 and Form 1040 -- Schedule D along with your other investment transactions.
In options trading, the simplest tax situation occurs when the option expires unused. In this case, the option is treated as a regular capital asset sale. Option writers have a cost basis of zero and a sales price equal to the premium value, plus any fees. Writers declare a short-term capital gain on the option's expiration date. This gain is always short term, even if the contract lasted longer than 12 months.
Option holders are the opposite. They have an asset sale with a cost basis equal to the premium plus fees and a sale price of zero. Holders write off an expired option premium as a loss, but they do get to declare a long-term loss if the contract lasted more than 12 months. In both cases, use the expiration date for the date sold. Writers write "expired" under cost basis, while holders use "expired" as the sale price on IRS Form 8949.
Exercised Options -- Calls
In an exercised call, the option writer sells an asset -- typically stock -- and the holder buys it. Writers add the value of the premium to the proceeds, or sale value, of the stock they sell and report the whole amount as one capital gain or loss trade. Holders add the premium amount to the cost basis of their shares. They do not need to do any reporting to the IRS until the stock is sold, where the option premium is included as part of the capital gain or loss transaction, just like it is with writers. The holding period for the stock starts on the date of stock purchase, not the date of the option purchase. You must hold the stock itself for 12 months or more to receive long-term gain treatment.
Exercised Options -- Puts
Puts are the opposite of calls for taxes. In a put, holders do the selling and add the cost of the option premium to the proceeds for the sale. Writers add the premium to the cost basis of the shares and use that number to calculate and report gain or loss only when the stock is sold.
Option holders may choose to sell a contract before its expiration date. In this case, the option contract is treated like any other sales transaction on Form 8949. If the holder makes money on the trade, it is a capital gain. Lose money, and it's a loss. Standard short- and long-term gain rules apply; if you held the contract for more than 12 months, it's a long-term gain or loss.
Wash Sales and Straddles
If you sell an options contract and then repurchase the same contract or one that is essentially equal within 30 days, it may be subject to the wash sale rule. The IRS does not allow investors to take a capital loss on wash transactions. There is a similar rule for straddle positions -- holding a put and call for the same strike price, expiration date and underlying asset. In this case, you cannot use a loss on on side of the straddle to reduce the gain on the other. Review IRS Publication 550 -- Investment Income and Expenses, or talk to a professional tax preparer for further information on these rules.