Tax treatment for options is diverse, including simple and complex trades on securities vs. Section 1256 contracts.

Options cover the gamut of tax treatment. They are a derivative of their underlying instrument and generally have the same tax treatment. For example, equity options are a derivative of the underlying equity, and both are taxed as securities.

Equity options are taxed as securities, and they include:

  • equity (stock) options
  • options on narrow-based indexes
  • options on securities ETFs organized as regulated investment companies (RIC)

Non-equity options are taxed as Section 1256 contracts and they include:

  • options on futures
  • options on broad-based indexes
  • options on commodity ETFs organized as publicly traded partnerships (PTP)
  • forex OTC options in Section 1256(g)
  • CBOE-listed options on volatility ETNs and ETFs

Wash-sale loss rules apply between substantially identical positions in securities, which means between equity and equity options, such as Apple stock and Apple stock options at different expiration dates. Because wash-sale loss rules only apply to securities, they do not apply to Section 1256 contracts, cryptocurrencies, ETNs structured as prepaid forward contracts, forex contracts, precious metals, or swap contracts.

Simple vs. complex option trades. Simple option trading strategies like buying and selling call and put options are known as “outrights.” Complex option trades known as “option spreads” include multi-legged offsetting positions like iron condors; butterfly spreads; vertical, horizontal and diagonal spreads; and debit and credit spreads.

Tax treatment for outright option trades is fairly straightforward. However, complex trades trigger a bevy of IRS rules geared toward preventing taxpayers from tax avoidance schemes: deducting losses and expenses from the losing side of the trade in the current tax year, while deferring income on the offsetting winning position until a subsequent tax year.

There are three things that can happen with outright option trades:

1. Trade option (closing transaction): Trading call and put equity options held as a capital asset is taxed the same as trading underlying equities. Report proceeds, cost basis, net capital gain or loss and holding period (short- vs. long-term held more than 12 months) from realized transactions only on Form 8949.

2. Option expires (lapses): There’s a minor twist on the above scenario. Rather than realizing a dollar amount on the closing out of the option trade, the closeout price is zero since the option expires worthless. Use zero for the realized proceeds or cost basis, depending on whether you’re the “writer “or “holder” of the option and if it’s a call or put. Use common sense — collecting premium on the option trade is proceeds and therefore the corresponding worthless exercise represents zero cost basis in this realized transaction. For guidance on entering option transactions as “expired” on Form 8949, read IRS Pub. 550 – Capital Gains And Losses: Options.

3. Exercise the option: This is where tax treatment becomes more complicated…

Excerpt from Green’s 2019 Trader Tax Guide