Taxation of options involves several key considerations that can significantly impact your net returns. The tax treatment depends on the type of option, the holding period, and whether the option is exercised or expires.
When you trade options, the holding period determines whether your gains are classified as short-term or long-term. If you hold an option for one year or less before selling it, the gain is considered short-term and taxed at your ordinary income tax rate, which can be as high as 37% for high-income earners. If you hold the option for more than one year, the gain is long-term and subject to the more favorable long-term capital gains tax rate, which maxes out at 20%. Same applies to when you write an option. If the option is exercised within one year of being written, the premium is taxed as a short-term capital gain.
If an option expires without being exercised, the premium you paid for the option becomes a capital loss (or capital gain if you wrote option). This loss can offset capital gains from other investments, and if your capital losses exceed your capital gains, you can use up to $3,000 of the excess loss to offset other income. Any remaining loss can be carried forward to future tax years.
When a call option you wrote is exercised, you’ll need to sell the underlying asset at the strike price. If you owned the underlying asset, the sale is treated as regular stock sale, and you’ll realize a capital gain or loss based on your cost basis, strike price and holding period. If you didn’t own the underlying asset, you’ll need to buy it at the current market price to deliver it. This could result in short-term capital loss. The premium you received is still considered income and taxed accordingly to holding period.
Be aware of wash sale rules. If you sell a stock at a loss and then buy the same or substantially identical stock within 30 days before or after sale, the loss is disallowed and added to the cost basis of the new stock. This rule can also apply to options.
Options on broad-based indices like the S&P 500 (SPX) are treated differently from options on index ETFs. Under IRC §1256, these options are considered “Section 1256 contracts” and benefit from a more favorable tax treatment. Section 1256 contracts include futures, options on futures, and cash-settled index options such as DJX, NDX, NQX, OEX, RUI, RUT, SPX, VIX, XEO, and XSP. Gains and losses from Section 1256 contracts are subject to a 60/40 rule: 60% of the gain or loss is treated as long-term capital gain or loss, and 40% is treated as short-term. This results in a blended tax rate that is generally lower than the rate for short-term gains. For example, if you’re in the highest tax bracket, the blended rate for Section 1256 contracts would be approximately 26.8% (60% of the gain taxed at 20% and 40% taxed at 37%). This favorable treatment can significantly reduce your tax liability compared to standard short-term gains. This rule is applied whether the option is exercised or expires worthless.
The other side of the §1256 coin — and the one that bites at year-end — is the mark-to-market rule. Every open §1256 position is treated as if you closed it at fair market value on December 31 and immediately reopened it on January 1 at that same price. The unrealized gain or loss on each open contract is dragged into that year’s tax return whether you wanted it there or not, with cost basis stepped to the year-end mark for the following year so the same dollars are not taxed twice. This is the defining feature of §1256, not a trap, but it has two real planning consequences. First, you can owe cash tax in April on a position you have not sold and may never sell at a profit: a deeply underwater short SPX put that you are holding into a January recovery still gets marked at December 31, and if that mark prints a gain you write a check. Second, mark-to-market interacts with year-end gain/loss harvesting in the opposite direction from equities — you cannot defer a §1256 gain into next year by refusing to close the position, and you cannot accelerate a §1256 loss by closing right before year-end since it would have been marked anyway. The takeaway: when you build a year-end tax plan, list your §1256 contracts separately from your equity book and estimate the December 31 mark as part of that year’s realized P&L, not next year’s.
Carefully monitor the holding periods of your options to take advantage of long-term capital gains rates.