Taxation of Equity Options

Equity options — options on individual stocks, on narrow-based indices, and on ETFs — are taxed under IRC §1234, “Options to buy or sell”. Broad-based index options and anything on a futures contract live in a completely different regime, described in section “Section 1256 Contracts and the 60/40 Regime”; get that classification right before anything else, because the two regimes disagree on almost every question that follows.

The single most important structural point: the premium is never taxed when it is paid or received. Nothing happens for tax purposes at the moment a contract is opened. The premium sits in suspense until the position closes, lapses, or is exercised, and only then does the Code decide what it was. Get this wrong — as a great deal of brokerage material does — and you will report income you do not owe, in a year you do not owe it.

If you bought the option. Your holding period is the holding period of the option itself , not of the underlying stock. Sell it after more than a year and the gain is long-term; sell it inside a year and it is short-term. Under IRC §1234(a)(1) the character follows the character the underlying property would have had in your hands, which for ordinary investors means capital. Let it expire worthless and IRC §1234(a)(2) deems it sold on the expiration date, so the premium becomes a capital loss with a holding period measured to that date. If instead you exercise, there is no gain or loss on the exercise — for a call you add the premium to the basis of the stock you just bought; for a put you subtract the premium from the amount realized on the stock you just sold. The clock on the newly acquired stock starts at exercise; it does not tack onto the option’s holding period.

If you wrote the option. This is where the common account is simply wrong. Three outcomes, three rules, and the writer’s own holding period is irrelevant in all of them:

It lapses, or you buy it back.

IRC §1234(b)(1) treats the gain or loss from any closing transaction, and gain on lapse, as gain or loss from a capital asset held not more than one year — short-term, always, no matter how long the option was open. A two-year LEAPSs call you wrote and let expire produces short-term gain. There is no holding period to manage here, so do not try.

Your written call is exercised.

The premium is not separate income. You add it to the amount realized on the stock sale and compute one gain or loss on the stock, using the stock’s basis and the stock’s holding period (Rev. Rul. 78-182). Sell appreciated shares you have held for years and the whole thing — premium included — is long-term capital gain.

Your written put is exercised.

Again no separate income. The premium reduces your basis in the stock you were put, which defers the benefit until you eventually sell those shares.

Wash sales reach options. IRC §1091 disallows a loss when you acquire substantially identical securities within 30 days before or after the sale, and an option to acquire the stock counts. Sell VOO at a loss on December 20 and buy a January call on it on December 28 and the loss is disallowed. The rule also runs in the other direction and across accounts — including retirement accounts, where the consequence is far worse; see section “The Four Reasons to Keep Derivatives Out”.

The covered-call holding-period trap, and the safe harbor. Write covered calls that are out-of-the-money and more than 30 days from expiration, on stock you have already held longer than a year. Do that and the tax machinery below never engages. Deviate and it does.

Stock plus a short call against it is a straddle under IRC §1092, which defers losses on the loss leg to the extent of unrecognized gain on the other. IRC §1092(c)(4) carves out an exception for a qualified covered call — an exchange-traded call, granted more than 30 days before expiration, that is not deep in the money, not written by an options dealer, and that produces capital rather than ordinary gain. Satisfy those and the straddle rules step aside.

Two consequences survive the safe harbor and catch people anyway. First, IRC §1092(f) suspends the stock’s holding period for any period during which you are the grantor of a qualified covered call that is in the money — so writing an ITM call against shares at month eleven can push your eventual sale into short-term territory. Second, a call that diminishes your risk of loss tolls the IRC §246(c)(4) holding period that qualifies a dividend for the 15/20% rate; write deep calls through an ex-dividend date and the dividend arrives as ordinary income.

The protective-put mirror of all this — IRC §1233(b) holding-period suspension, the § 1233(c) married-put exception, and the § 1092 deferral on hedged appreciated stock — is worked through with examples in section “Taxation of Hedging Contracts”. Collars and prepaid variable forwards combine both sets of rules and are treated in section “Asymmetric Tail Hedging for Concentrated Equity”.