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Taxes on Option Trades
Tax day is just around the corner, and for options traders that means you better get intimately acquainted with Schedule D of your tax return. This is the form where you report your capital gains and losses for the year, and if you’re like most options traders, you’ll have plenty of short-term, and likely some long-term, capital gains and losses to cope with.
Now, before we go any further, I recommend that anyone who trades options use a CPA or tax professional to help prepare his or her return. Yes, you can use tax preparation software if you feel confident that you’ve kept good track of all your trades throughout the year, but if questions arise about a particular transaction you may be left on your own trying to decipher the answer. With a CPA or tax professional at your side, most any question can likely be dealt with quickly and easily.
So, how do you treat options on your tax return?
Well, first it matters whether you’re an options holder or an options writer. Let’s start by looking at what the tax treatment and issues are if you’re an options holder.
Taxes for Option Buyes
When you own either put or call options, there are essentially three things that can happen.
First, your options can expire worthless, in which case the amount of money you paid for the option would be a capital loss. If it’s a long-term option held for more than a year, the loss would be considered a long-term capital loss rather than a short-term loss.
The second thing that can happen is you can sell your option before expiration, and the difference between the price you paid for the option and the price you sold it for is the profit or loss you must report on your taxes.
The third thing that can happen is you can exercise your put or call option.
In the case of puts, you can exercise the option by selling your shares to the writer. In this situation, you would subtract the cost of the put option from the amount of the sale, and your gain or loss would either be short or long term depending on how long you held the underlying shares.
With call options, you exercise a call by buying the designated number of shares from the options writer. You then add the cost of the call option to the price you paid for the stock, and that is your cost basis. Then when you sell the stock your gain or loss will be either short or long term depending on how long you hold the shares.
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Taxes for Option Writers
If you’re an options writer, the rules are different, but they too basically fall into two main categories.
First, if you write an option and that option expires unexercised, the premium payment you received becomes a short-term capital gain.
Second, if you write a put or call option, and that option gets exercised, the transactions are treated in the following way:
In the case of a put option that’s exercised, as the writer of that put you have to buy the underlying stock. That means you can reduce your cost basis for tax purposes by the amount you collected for the put option.
As for call options, you have to add the premium collected to the total proceeds of your sale, and the gain or loss is dealt with on Schedule D according to how long you’ve held the underlying shares.
Now, there are many more considerations when dealing with options and your tax returns, but like so many issues with taxes, they need to be dealt with on an individual basis given your specific tax picture. That is why I highly recommend employing a tax professional to help you out, especially if your options trades include straddles, butterflies, condors or other positions that you aren’t sure how to account for on that Schedule D.
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Tax Treatment For Call & Put Options
It is absolutely crucial to build at least a basic understanding of tax laws prior to embarking upon any options trades. In this article, we will look at how calls and puts are taxed in the US, namely, calls and puts for the purpose of exercise, as well as calls and puts traded on their own. We will also look at the “Wash Sale Rule” and the tax treatment of option straddles. But before we go any further, please note that the author is not a tax professional and this article should only serve as an introduction to the tax treatment of options. Further due diligence or consultation with a tax professional is highly recommended.
- If you’re trading options, chances are you’ve triggered some taxable events that must be reported to the IRS.
- While many options profits will be classified as short-term capital gains, the method for calculating the gain (or loss) will vary by strategy and holding period.
- Exercising in-the-money options, closing out a position for a gain, or engaging in covered call writing will all lead to somewhat different tax treatments.
Firstly, when call options are exercised, the premium is included as part of the cost basis of a stock. For example, if Mary buys a call option for Stock ABC in February with a $20 strike price and June 2020 expiry for $1, and the stock trades at $22 upon expiry, Mary exercises her option. Her cost basis for the 100 shares of ABC is $2100 ($20 per share x 100, plus $100 premium). If Mary decides to sell her position of 100 shares in August when ABC is now trading at $28, she will realize a taxable short-term capital gain of $700: $28 to sell the shares that cost her $21 to receive. For brevity sake, we will forgo commissions, which can be tacked onto the cost basis of her shares. The tax time period is considered short-term as it is under a year, and the range is from the time of option exercise (June) to time of selling her stock (August).
Put options receive a similar treatment: if a put is exercised and the buyer owned the securities, the put’s premiums and commissions are added to the cost basis of the shares/ subtracted from the selling price upon exercise. The position’s elapsed time begins from when the shares were originally purchased to when the put was exercised (shares were sold). If a put is exercised without prior ownership of the underlying stock, similar tax rules to a short sale are applied, with the total time period ranging from exercise date to closing/ covering 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 call /put writes, all options that expire unexercised are considered short-term gains. Below is an example that covers some basic scenarios:
Bob purchases an October 2020 put option on XYZ with a $50 strike in May 2020 for $3. If he subsequently sells back the option when XYZ drops to $40 in September 2020, he would be taxed on short-term capital gains (May to September) or $10 minus the put’s premium and associated commissions. In this case, Bob would be eligible to be taxed on a $7 short-term capital gain.
If Bob writes a call $60 strike call for ABC in May, receiving a premium of $4, with an October 2020 expiry, and decides to buy back his option in August when XYZ jumps to $70 on blowout earnings, then he is eligible for a short term capital loss of $600 ($70 – $60 strike + $4 premium received).
If, however, Bob purchased a $75 strike call for ABC for a $4 premium in May 2020 with an October 2020 expiry, and the call expires unexercised (say XYZ will trade at $72 at expiry), Bob will realize a long-term capital loss on his unexercised option equal to the premium of $400.
Covered calls are slightly more complex than simply going long or short a call. With a covered call, somebody who is already long the underlying will sell upside calls against that position, generating premium income buy also limiting upside potential. Taxing a covered call can fall under one of three scenarios for at or out-of-the-money calls: (A) call is unexercised, (B) call is exercised, or (C) call is bought back (bought-to-close).
We will revisit Mary for this example:
- Mary owns 100 shares of Microsoft Corporation (MSFT), trading at $46.90, and she writes a $50 strike covered call, with September expiry, receiving a premium of $0.95.
- If the call goes unexercised, say MSFT trades at $48 at expiration, Mary will realize a short-term capital gain of $0.95 on her option.
- If the call is exercised, Mary will realize a capital gain based on her total position time period and her total cost. Say she bought her shares in January of 2020 for $37, Mary will realize a long-term capital gain of $13.95 ($50 – $36.05 or the price she paid minus call premium received).
- If the call is bought back, depending on the price paid to buy the call back and the time period elapsed in total for the trade, Mary may be eligible for long- or short-term capital gains/losses.
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.
When writing ITM covered calls, the investor must first determine if the call is qualified or unqualified, as the latter of the two can have negative tax consequences. If a call is deemed to be unqualified, it will be taxed at the short-term rate, even if the underlying shares have been held for over a year. The guidelines regarding qualifications can be intricate, but the key is to ensure that the call is not lower by more than one strike price below the prior day’s closing price, and the call has a time period of longer than 30 days until expiry.
For example, Mary has held shares of MSFT since January of last year at $36 per share and decides 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 since the expiry is less than 30 days away, her covered call is unqualified and the holding period of her shares will be suspended. If on June 5, the call is exercised and Mary’s shares are called away, Mary will realize short-term capital gains, even though the holding period of her shares were over a year.
For a list of guidelines governing covered call qualifications, please see the official IRS documentation here, as well as, a list of specifications regarding qualified covered calls can also be found at Investor’s Guide.
Protective puts are a little more straightforward, though barely just. If an investor has held shares of a stock for more than a year, and wants to protect their position with a protective put, he or she will still be qualified for long-term capital gains. If the shares had been held for less than a year, say eleven months, and if the investor purchases a protective put- even with more than a month of expiry left, the investor’s holding period will immediately be negated and any gains upon sale of the stock will be short term gains. The same is true if shares of the underlying are purchased while holding the put option before the option’s expiration date—regardless of how long the put has been held prior to the share purchase.
Wash Sale Rule
According to the IRS, losses of one security cannot be carried over towards the purchase of another “substantially identical” security within a 30-day time-span. The wash sale rule applies to call options as well.
For example, if Beth takes a loss on a stock, and buys the call option of that very same stock within thirty days, she will not be able to claim the loss. Instead, Beth’s loss will be added to the premium of the call option, and the holding period of the call will start from the date that she sold the shares. Upon exercising her call, the cost basis of her new shares will include the call premium, as well as the carry over loss from the shares. The holding period of these new shares will begin upon the call exercise date.
Similarly, if Beth were to take a loss on an option (call or put) and buy a similar option of the same stock, the loss from the first option would be disallowed, and the loss would be added to the premium of the second option.
Finally, we conclude with the tax treatment of straddles. Tax losses on straddles are only recognized to the extent that they offset the gains on the opposite position. If Chris were to enter a straddle position, and disposes of the call at a $500 loss, but has unrealized gains of $300 on the puts, Chris will only be able to claim a $200 loss on the tax return for the current year.
The Bottom Line
Taxes on options are incredibly complex, but it is imperative that investors build a strong familiarity with the rules governing these derivative instruments. This article is by no means a thorough presentation of the nuisances governing option tax treatments and should only serve as a prompt for further research. For an exhaustive list of tax nuisances, please seek a tax professional.
How to Report Foreign Earned Income on your US Tax Return
If you are a U.S. citizen or resident alien, you must report income from sources outside the United States (foreign income) on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form W2, Wage and Tax Statement, or Form 1099 from the foreign payer. This applies to earned income (such as wages and tips) as well as unearned income (such as interest, dividends, capital gains, pensions, rents, and royalties). If you reside outside the United States, you may be able to exclude part or your entire foreign source earned income.
Tax on Foreign Income
If you are a US citizen or resident alien, you need to pay tax on foreign income. If you paid any tax on foreign income in your respective country you may get a tax benefit from the US government, but there is also a limit of exclusion for foreign income.
Reporting Your Foreign Income
If you are a U.S. citizen or resident during tax year, you likely have foreign income that you must report on your tax return. Here we help you to understand a few concepts affecting foreign income.
The main foreign income concepts (explained below) are:
- General Rules Regarding Foreign Income
- The Foreign Tax Credit
- The Foreign Earned Income Exclusion
- Reporting Foreign Financial Assets and Accounts
General Rules Regarding Foreign Income
1. What foreign income is taxable on my U.S. return?
If you are a U.S. citizen or resident, you are required to report your worldwide income on your tax return. This means that you must not only report income you receive from U.S. sources, but you must also report income you receive from foreign sources.
2. Where do I report the foreign income on my return?
Generally, you report your foreign income where you normally report your U.S. income on your tax return. Earned income (wages) is reported on line 7 of Form 1040; interest and dividend income is reported on Schedule B; income from rental properties is reported on Schedule E, etc.
The Foreign Tax Credit
Since it is likely your foreign source income will be taxed by both the U.S. and a foreign country, there is a Foreign Tax Credit. The foreign tax credit helps to ensure that you are only taxed once on the foreign source income, but at the higher of the foreign or U.S. income tax rates on that income.
The Foreign Earned Income Exclusion
If you meet certain tests related to the length and nature of your stay in a foreign country, you may qualify to exclude some of your foreign earned income from your tax return. You may also be able to exclude or deduct some of your reimbursed housing costs. You cannot exclude or deduct more than your foreign earned income for the year. For 2020, the maximum foreign earned income exclusion is $99,200.
Reporting Foreign Financial Assets and Accounts
There has been a requirement for many years to report foreign income, referred to as FBAR (foreign bank and financial accounts report). You must report any foreign financial assets or accounts that meet certain thresholds. Generally, a report on foreign accounts is required if you hold in the aggregate more than $10,000.
Reportable Financial Accounts
The following types of financial accounts are reportable, meaning you must report these on your U.S. tax return.
- “Account” is broadly defined to include any foreign bank, securities, or other financial accounts.
- “Bank accounts” include savings deposits, demand deposits, checking accounts, and any other accounts maintained with a person engaged in the business of banking.
- “Securities accounts” include accounts maintained with a person in the business of buying, selling, holding, or trading stock or other securities.
- “Other financial accounts” include:
- An account with a person that is in the business of accepting deposits as a financial agency;
- An account that is an insurance policy with a cash value or an annuity policy;
- An account with a person that acts as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association; or
- An account with a mutual fund or similar pooled fund which issues shares available to the general public that have a regular net asset value determination and regular redemptions (does NOT include hedge funds).
Form 8938, Statement of Specified Foreign Financial Assets:
This is a relatively new form filed with your Form 1040 and is used to report specified foreign financial assets. The reporting threshold for FATCA depends on filing status and whether the taxpayer is living within the U.S. or abroad.
What are the Reporting Thresholds for Domestic Taxpayers?
Unmarried taxpayers living in the U.S.: The total value of specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.
Married taxpayers filing a joint income tax return and living in the U.S.: The total value of specified foreign financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year.
What are the reporting thresholds for taxpayers living abroad?
You are filing a return other than a joint return and the total value of your specified foreign assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year.
You are filing a joint return and the value of your specified foreign asset is more than $400,000 on the last day of the tax year or more than $600,000 at any time during the year.
How do I report interest I earned on a foreign bank account?
You must report interest earned on a foreign bank account as part of your worldwide income if you are one of these:
Report this interest with domestic interest income on Form 1040. You’ll also file Schedule B if you had one of these for a financial account in a foreign country:
- Interest in
- Signature authority over
This applies even if you had less than $1,500 or more of total interest and/or dividends for the year. Convert the foreign currency into U.S. dollars at the current exchange rate when you receive the income. If there’s more than one exchange rate, use the rate that most properly reflects the income.
The income might be taxable to both the United States and the foreign country. If so, you can claim a foreign tax credit on taxes paid to the other country.
Usually only U.S. citizens and resident aliens must include this income on their return. However, if you’re identified as a U.S. person, you have to report foreign bank accounts to the IRS. This is true as long as both of these apply:
- You have a financial interest in or signature authority over one or more accounts in a foreign country. This includes bank accounts and securities accounts.
- The total value of all foreign financial accounts is more than $10,000 at any time in the year.
A U.S. person is any of these:
- A citizen or resident of the United States
- A person doing business in the United States on a regular and ongoing basis
- A domestic corporation
- A domestic estate or trust
If these tests apply to you, you meet the reporting conditions when you do both of these:
- Check the appropriate FBAR-related federal return questions. The questions are found on:
- Form 1040, Schedule B
- Form 1041, Other Information
- Form 1065, Schedule B
- Form 1120, Schedule N
- If the foreign financial account is worth more than $10,000 at any time in the year, you must report it. Do so by filing FinCEN 114: Report of Foreign Bank and Financial Accounts. Unlike the previous form TD F 90-22.1, you can’t mail the form. You must file it online.
What are the consequences for Evading Taxes on Foreign Source income?
You will face serious consequences if the IRS finds you have unreported income or undisclosed foreign financial accounts. These consequences may include, but are not limited to, additional taxes, substantial penalties, interest, fines, and even imprisonment.
Sudhir Pai, CPA, FCA, EA, CGMA
Sudhir is a CPA specializing in Accounting, Financial advisory, Tax & Business Consulting Services with broad experience in all aspects of accounting, administration, tax compliance, audit, and financial management. With over 20 years of experience, he is a Chartered Accountant from India and a Certified Public Accountant in the USA. He also leads a firm of CPAs that proactively understand, identifies and find a suitable solution for the clients.
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