Options trading has become increasingly popular, but the tax treatment can be confusing. Different types of options have different rules, and what happens when you close, exercise, or let an option expire all affects your taxes differently. This comprehensive guide explains how options are taxed.
Two Categories of Options
The IRS divides options into two main categories with different tax treatment:
Equity Options: Options on individual stocks and ETFs. These are taxed as short-term or long-term capital gains based on holding period.
Section 1256 Contracts: Index options (SPX, RUT, NDX) and futures. These receive special 60/40 tax treatment regardless of holding period.
Equity Options Tax Treatment
Options on individual stocks and ETFs follow standard capital gains rules. The tax treatment depends on what happens to the option:
Option Closed Before Expiration
When you buy to close or sell to close an option position:
- Holding period: Measured from when you opened to when you closed
- Short-term: Held 1 year or less (taxed at ordinary income rates)
- Long-term: Held more than 1 year (taxed at 0%, 15%, or 20%)
Closed Option Example
You buy a call option for $500 and sell it 3 months later for $800:
- Gain: $300
- Holding period: 3 months (short-term)
- Tax treatment: Short-term capital gain
- If in 24% bracket: $72 tax
Option Expires Worthless
When an option expires worthless:
- Option buyer: Capital loss equal to the premium paid
- Option seller: Capital gain equal to the premium received
- Expiration date: The date the gain or loss is realized
Option Exercised
When an option is exercised, it affects the cost basis or sale price of the underlying stock:
Call Option Exercised (Buyer)
You buy a $100 call for $5 and exercise it:
- Strike price: $100
- Premium paid: $5
- Cost basis of stock: $105 per share
- Holding period for stock: Starts at exercise
Put Option Exercised (Buyer)
You buy a $100 put for $5 and exercise it (you already own the stock):
- Sale price: $100
- Premium paid: $5
- Net sale price: $95 per share
- Holding period: Based on when you bought the stock
Option Assigned
When you are assigned on a short option:
- Short call assigned: Premium added to sale price of stock you deliver
- Short put assigned: Premium reduces cost basis of stock you receive
Section 1256 Contracts (Index Options)
Index options on broad-based indexes like SPX, RUT, and NDX receive special tax treatment under Section 1256:
60/40 Rule: Regardless of holding period, gains and losses are treated as 60% long-term and 40% short-term capital gains.
Benefits of Section 1256
- Lower effective tax rate: Blended rate is lower than short-term rates
- No holding period requirement: Day trades get 60/40 treatment
- Loss carryback: Net Section 1256 losses can be carried back 3 years
- Mark-to-market: Open positions are marked to market at year-end
Section 1256 Tax Savings
You make $10,000 in SPX options profits with a 1-day holding period. You are in the 32% bracket:
- Equity option tax: $10,000 x 32% = $3,200
- Section 1256 tax:
- 60% long-term: $6,000 x 15% = $900
- 40% short-term: $4,000 x 32% = $1,280
- Total Section 1256 tax: $2,180
- Tax savings: $1,020
Options and Wash Sales
Options can trigger wash sales in several ways:
- Selling stock at a loss and buying a call: Wash sale triggered
- Selling stock at a loss and selling a put: Wash sale triggered
- Closing an option at a loss and opening a similar position: Potentially a wash sale
- Deep in-the-money options: More likely to be substantially identical
Spreads and Complex Strategies
Credit Spreads
Each leg of a credit spread is tracked separately:
- Short option: Gain or loss when closed, assigned, or expired
- Long option: Gain or loss when closed, exercised, or expired
- Net result is reported as two separate transactions
Debit Spreads
Similar to credit spreads, each leg is tracked separately for tax purposes.
Iron Condors and Other Multi-Leg Strategies
Each option in a multi-leg strategy is a separate tax event. Track the cost basis and holding period for each leg individually.
Covered Calls
Covered calls have special rules:
- Call expires worthless: Premium is a short-term capital gain
- Call bought to close: Gain or loss on the option itself
- Call assigned: Premium added to sale price of stock
Qualified Covered Calls: If your covered call meets certain requirements, it does not affect the holding period of your stock. Non-qualified covered calls can reset your stock's holding period.
Tax Reporting for Options
Your broker reports options transactions on Form 1099-B. You must report on Schedule D and Form 8949. Key information to track:
- Date opened and date closed
- Premium paid or received
- Whether exercised, assigned, or expired
- Holding period (short-term or long-term)
- Wash sale adjustments if applicable
Employee Stock Options
Employee stock options (ISOs and NQSOs) have completely different tax rules:
Incentive Stock Options (ISOs)
- No tax at grant or exercise (for regular tax purposes)
- AMT may apply at exercise
- Favorable long-term capital gains if held 1 year after exercise and 2 years after grant
Non-Qualified Stock Options (NQSOs)
- No tax at grant
- Ordinary income at exercise (spread between market price and exercise price)
- Capital gains treatment on subsequent appreciation
Track Your Options Taxes Automatically
Pro Trader Dashboard tracks all your options trades, calculates cost basis adjustments for exercise and assignment, and identifies wash sales. Simplify your options tax reporting.
Year-End Tax Planning for Options
Consider these strategies before year-end:
- Close losing positions: Realize losses to offset gains
- Review Section 1256 positions: They are marked to market on Dec 31
- Watch for wash sales: 30-day window extends into January
- Consider tax bracket: Time gains and losses strategically
- Carryback Section 1256 losses: If applicable, amend prior returns
Common Options Tax Mistakes
- Treating index options like equity options: Missing Section 1256 benefits
- Forgetting cost basis adjustments: When options are exercised or assigned
- Ignoring wash sale rules: Options can trigger wash sales on stocks
- Not tracking each leg separately: Multi-leg strategies need individual tracking
- Confusing employee stock options: Different rules than traded options
Summary
Options tax treatment depends on the type of option and what happens to it. Equity options follow standard capital gains rules based on holding period. Section 1256 contracts (index options) receive favorable 60/40 treatment regardless of holding period. Exercise and assignment create cost basis adjustments for the underlying stock. Keep detailed records of all options transactions and be aware of wash sale implications.
Learn more about trading taxes in our guides on Section 1256 contracts and trader tax status.