Understanding Tax Rules for Call and Put Options in the U.S.

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Trading options can have significant tax implications depending on the type of option, how long you hold it, and the strategies you use. The tax rules can be complex, with different treatments for calls versus puts, long versus short positions, and strategies like covered calls or spreads.

Understanding how these rules work and knowing when trades create taxable events that you’ll need to report to the IRS can help you make more informed decisions and avoid surprises at tax time. We walk you through the main points below.

Tax Implications of Exercising Options

The tax treatment when exercising options depends on how long you hold both the option and any resulting stock position. The rules also differ for calls and puts.

Tax Rules for Exercising Call Options

When you exercise a call option, the premium paid becomes part of your cost basis in the stock purchase.

For example, if you buy a call option on Company ABC with a $20 strike price for a $1 premium ($100 total for one contract of 100 shares) and exercise it when the stock is at $22, your total cost basis would be $2,100 ($20 × 100 shares plus the $100 premium).

The key to determining how these trades are taxed is the holding period of the resulting stock position. If you sell the shares within a year of exercising the option, you’ll realize a short-term capital gain taxed at ordinary income rates. However, if you hold the shares for at least 366 days after exercising the option, any gain qualifies for long-term capital gains treatment, potentially resulting in significant tax savings.

For instance, using the example above, if you exercise the option in June one year and hold until July the next year when the stock is at $28, you’d realize a long-term capital gain of $700 ($2,800 in proceeds minus the $2,100 cost basis).

This gain would qualify for the preferential long-term capital gains tax rate, while selling only two months later (in August of the first year) would result in a short-term gain taxed at higher ordinary income rates.

Understanding Taxes on Exercising Put Options

Put options follow similar principles but with some important differences. When exercising a put option, the premium paid plus any commissions are added to the cost basis if you already own the underlying securities. This total is then subtracted from the proceeds when the shares are sold. The holding period for tax purposes runs from when you initially bought the shares to when you exercise the put and sell the shares.

If you exercise a put without previously owning the underlying stock (called a naked put), different rules apply. In this case, the holding period begins on the exercise date and ends when you close or cover the position. These transactions generally result in short-term capital gains or losses, similar to how short sales work.

Tax Considerations for Pure Options Trading

When trading options without exercising them (buying and selling the contracts themselves), the tax treatment follows specific rules for both long and short positions. Here’s how different scenarios are taxed:

Long Options (Buying Calls or Puts)

• If you close the position by selling the option, the holding period determines whether it’s a short-term or long-term gain/loss.
• If the option expires worthless, the loss follows the same holding period rules: long-term if held over a year, short-term if under a year.

Short Options (Writing Calls or Puts)

• All gains or losses from short options positions are treated as short-term, regardless of how long you hold the position.
• This includes the premium received when options expire worthless
• The same short-term treatment applies when you buy back the option to close the position

For example, if you buy a put option in May for $300 ($3 premium × 100 shares) and sell it in September of the same year for $200, you’d have a short-term capital loss of $100. However, if you had held that same put option for over a year before selling, any gain or loss would qualify as long-term.

Tax Treatment for Covered Call Strategies

Covered calls present a more complex tax scenario because they involve owning the stock and writing options. The tax treatment depends on several factors, particularly whether the call options are “qualified” or “unqualified.”

Qualified Covered Calls (QCCs)

These must meet two main criteria:

1. The expiration date must be more than 30 days from when you write the option.
2. The strike price must be reasonably close to the current stock price. Thus, your position can’t be “deep in the money,” which means the strike price can’t be significantly below the current market price. The IRS provides specific guidelines for how far below the strike price can be based on the stock’s price range.

For QCCs, there are three main tax scenarios:

1. The call expires unexercised:

• The premium received is always treated as a short-term capital gain.
• This applies no matter how long you’ve held the underlying stock.

2. The call is exercised:

• The premium received is added to the stock’s sale price.
• The holding period of the underlying stock determines if the total gain is long- or short-term.
• If you’ve held the stock for over a year before the call is exercised, the entire gain (including the premium) qualifies for long-term capital gains treatment.

3. The call is bought back:

• The difference between the premium received and the buyback price creates a gain or loss.
• This gain or loss is typically short-term, no matter the holding period.

Unqualified Covered Calls

If your covered call is unqualified (meaning it doesn’t meet the 30-day requirement or the strike price is too far below the current market price), the tax implications are generally less favorable. The most significant consequence is that writing an unqualified covered call can suspend the holding period of your underlying stock.

This means that even if you’ve held the stock for over a year, you might not qualify for long-term capital gains treatment when you sell the shares. For example, if you’ve held stock for 11 months and write an unqualified covered call, the holding period stops counting until the position is closed. This could prevent you from reaching the one-year threshold needed for long-term capital gains treatment, potentially resulting in higher taxes when you sell the shares.

Examples

Let’s say you own 100 shares of Company ABC trading at $50 per share. Let walk through two different scenarios—one where the covered call is qualified and another in which it isn’t.

Example of a QCC

Suppose you write a call option as follows:

• Strike price: $52.50 (reasonably close to the current price)
• Expiration: 45 days from now
• Premium received: $1.50 per share

This would be a qualified covered call because:

• The strike price isn’t deep in the money (only $2.50 above market)
• The expiration is more than 30 days away

Example of an Unqualified Covered Call

Now, suppose you write a call option as follows:

• Strike price: $40 (much lower than current price)
• Expiration: 25 days from now
• Premium received: $10.50 per share

This would be unqualified because:

• The strike price is deep in the money ($10 below the market price)
• The expiration is less than 30 days away

The tax consequences are significantly different. In the first example, if you held the stock for over a year, you would be eligible for long-term capital gains treatment. In the second example, your holding period for the stock stops, potentially preventing you from qualifying for long-term capital gains rates.

Taxation on Protective Puts: Key Points

Protective puts are a little more straightforward—but not by much. If you’ve held shares for more than a year before buying a protective put, you can still be eligible for long-term capital gains treatment on the stock. However, if you’ve held the shares for less than a year when you buy the protective put, the holding period immediately stops.

This means that any subsequent gains from selling the stock would be taxed as short-term gains, even if you owned the shares for more than a year in total.

The timing also matters when purchasing stock while holding a put option. If you buy shares any time before the put expires, the holding period for those shares starts fresh from the purchase date, regardless of how long you’ve held the put. This can impact your ability to qualify for long-term capital gains treatment.

Navigating the Wash Sale Rule for Options

The wash sale rule, which prevents traders from claiming tax losses while maintaining similar market exposure, applies to options just as it does to stocks. However, as with everything in this area of investing, it can be more complex.

Here’s how the rule works with options:

• If you sell a stock at a loss and buy a call option on the same stock within 30 days before or after the sale, you cannot claim the loss.
• If you close an options position at a loss and open a similar position within the 30-day window, the loss is disallowed.
• The loss isn’t permanently disallowed, however. Instead, it’s added to the cost basis of the new position.

Example

If you sell Stock ABC at a $1,000 loss and then buy calls on ABC two weeks later, the $1,000 loss would be disallowed under the wash sale rule. Instead, the loss would be added to the cost basis of your call options.

Similarly, if you close out a call option at a loss and buy another call option on the same stock with a similar strike price and expiration within 30 days, the wash sale rule would apply here too.

The rules become particularly important during tax planning season when traders might be considering closing positions to harvest tax losses. The moral of the story is that it’s crucial to wait the full 30 days before entering similar positions if you want to claim the tax loss.

Tax Strategies for Handling Straddle Losses

For tax purposes, a straddle occurs when you hold offsetting positions that substantially reduce your risk of loss. The most common example is simultaneously holding both a put and call option on the same security with very similar strike prices and expiration dates.

The key tax rule for straddles is that losses are only recognized to the extent they exceed unrealized gains in the offsetting position.

For example, if you close the call side of a straddle at a $500 loss but have unrealized gains of $300 on the put side, you can only claim $200 of the loss in the current tax year. The remaining $300 loss is deferred until you close the offsetting position.

This rule prevents traders from claiming tax losses while maintaining potential profits in related positions. The deferred loss isn’t lost forever—it’s just postponed until you close out the entire position.

The Bottom Line

Options taxation is one of the more complex areas of investment tax law. While basic options trades are pretty straightforward, strategies involving multiple legs or combined stock-and-options positions can trigger special tax rules.

Understanding these rules before implementing your strategies can help you make more tax-efficient trading decisions. Given the complexity, it’s wise to consult a tax professional with experience in options trading before pursuing more sophisticated strategies.