SM: Taxes on Options: Puts and Calls

FOR individual investors out there dabbling in stock options for the first time, you need to know how these securities get taxed.

For advice on those, see "Taxes on Incentive Stock Options" and "Avoiding the AMT When Exercising ISOs No, this time we're talking about people who are using puts to lock in their profit on an IBM and calls to wager on the continued climb of the latest stock-market darling.

For the uninitiated, lets start with some definitions. A put option gives the "holder" (the option owner) the right to sell a specified publicly traded stock at a set price ("strike price") on or before a specified date. A call option, on the other hand, gives the holder the right to buy a security at a set price.

Now if instead of buying an option, you grant someone else a put or call option, you are an option "writer." As such, you receive a "premium" (fee) from the holder in return for taking the risk.

As a holder, you can acquire your option either by paying a premium to a writer for a newly issued option or by purchasing an existing option on the open market.

Now for the tax rules:

Option Holders If you hold options, they will either: (1) expire unexercised on the expiration date because they are worthless, (2) be exercised because they are "in the money" or (3) be sold before they expire.

If your option expires, you have obviously sustained a capital loss usually short term because you held the option for one year or less. But if it was held longer, you have a long-term capital loss. For example, say you buy a six-month put option with a strike price of $10 per share. On the expiration date the stock is selling for $20. If you have any sense, you'll let the option expire and thereby incur a short-term capital loss. Report the loss which is the price (or premium) you paid for the put, plus transaction costs on Part I of Form 8949, which feeds into Schedule D, by entering the option-purchase date in column (c), the expiration date in column (d), "expired" in column (e), and the cost, including transaction fees, in column (f).

If you exercise a put option by selling stock to the writer at the designated price, deduct the option cost (the premium plus any transaction costs) from the proceeds of your sale. Your capital gain or loss is long term or short term depending on how long you owned the underlying stock. Enter the gain or loss on Form 8949, just as you would for any stock sale.

If you exercise a call option by buying stock from the writer at the designated price, add the option cost to the price paid for the shares. This becomes your tax basis. When you sell, you will have a short-term or long-term capital gain or loss depending on how long you hold the stock. That means that your holding period is reset when you exercise the option.

For example, say you spend $1,000 on a July 12, 2011, call option to buy 300 shares of XYZ Corp. at $15 per share. On July 1 of 2011, it's selling for a robust $35, so you exercise. Add the $1,000 option cost to the $4,500 spent on the shares (300 times $15). Your basis in the stock is $5,500, and your holding period begins on July 2, the day after you acquire the shares.

If you sell your option, things are simple. You have a capital gain or loss that is either short term or long term, depending on your holding period.

Option Writers As mentioned, option writers receive premiums for their efforts. The receipt of the premium has no tax consequences for you, the writer, until the option: (1) expires unexercised, (2) is exercised or (3) is offset in a "closing transaction" (explained below).

When a put or call option expires, you treat the premium payment as a short-term capital gain realized on the expiration date. This is true even if the duration of the option exceeds 12 months. For example, say you wrote a April 5, 2011, put option at $25 per share for 1,000 shares of XYZ Corp. for a $1,500 premium. This creates an obligation for you to buy 1,000 shares at a strike price of $25. Fortunately for you, the stock soars to $35, and the holder wisely allows his option to expire. You treat the premium as a $1,500 short-term capital gain. Report it on Part I of Form 8949 as follows: Enter the April 6, 2010, expiration date in column (c), the $1,500 as sales proceeds in column (e), "expired" in column (f). If you wrote the option in the year before it expires, there are no tax consequences in the earlier year.

If you write a put option that gets exercised (meaning you have to buy the stock), reduce the tax basis of the shares you acquire by the premium you received. Again, your holding period starts the day after you acquire the shares.

If you write a call option that gets exercised (meaning you sell the stock), add the premium to the sales proceeds. Your gain or loss is short term or long term, depending on how long you held the shares.

With a closing transaction, your economic obligation under the option you wrote is offset by purchasing an equivalent option. For example, say you wrote a put option for 1,000 shares of XYZ Corp. at $50 per share with an expiration date of July 12, 2011. While this obligates you to buy 1,000 shares at $50, it can be offset by purchasing a July 12 put option for 1,000 shares at $50 per share. You now have both an obligation to buy (under the put option you wrote) and an offsetting right to sell (under the put option you bought). For tax purposes, the purchase of the offsetting option is a closing transaction because it effectively cancels the option you wrote. Your capital gain or loss is short term by definition. The amount is the difference between the premium you received for writing the option and the premium you paid to enter into the closing transaction. Report the gain or loss in the tax year you make the closing transaction.

Straddles For purposes of deducting losses from options, the preceding rules apply to so-called naked options. If you have an "offsetting position" with respect to the option, you have a "straddle." An example of a straddle is when you buy a put option on appreciated stock you already own but are precluded from selling currently under SEC rules. Say the put option expires near the end of the year. If you still own the offsetting position (the stock) at year's end, your loss from the expired option is generally deductible only to the extent it exceeds the unrealized gain on the stock. Any excess loss is deferred until the year you sell the stock. See IRS Publication 550 for more on straddles.