Tax Implications of Options Trading

There are ways to minimize tax liability by taking advantage of short-term and long-term tax rates.

There are ways to minimize tax liability by taking investment gains after they are held for more than one year and booking investment losses by holding them less then one year. Whether the investment security is an option or stock, the rules are the same. Options that expire worthless also is another tax topic to think about before trading options.

Option

An option is a contract that provides the owner with the opportunity of buying or selling short 100 shares of a security at a specified price by a certain date. There are two different options: call and put. A call option allows the owner to buy shares while a put option gives the owner the option of selling shares short. It does not make sense to exercise a call option unless the underlying security's price is higher than the strike price. It does not make sense for a person to exercise a put option unless the underlying security's price is below the exercise price. The owner does not have to exercise the option and can let it expire without taking any actions. An option is usually quoted with what the date of the expiration is and the exercise price.

Short Term

Trading options is just like trading stocks except there is an expiration date. The IRS characterizes short-term trading as a holding period of less than one year. A short-term trade is buying and selling the security within a one-year period. There are no tax advantages for short-term trading, which is taxed at the taxpayer's regular tax rate. If a taxpayer purchased an option contract and it expired within one year, the taxpayer is able to take the loss under the short-term losses.

Long Term

The option profit or loss is taxed at a long-term capital gain tax rate if the option is held for more than one year. Long-term rates are usually lower than short-term rates. The current long-term capital gain tax rate is 15 percemt. If an option expires worthless a taxpayer receives a tax break. If the option is bought and it expires more than a year after it was bought, the loss is calculated at the long-term capital gain tax rate.

Losses And Gains

Because short-term and long-term gains and losses are taxed at different tax rates. It is smart to take advantage of the tax rates by trying to hold stocks with gains over a year period and taking losses within a year of holding the option. This way, a taxpayer will be able to minimize tax liability and take advantage of deducting losers at a higher tax rate and booking winners at a lower tax rate. Note, the long-term capital gain rate may not be more than the regular tax rate, so it is wise to make sure what tax bracket a taxpayer is in.

References

• IRS.gov: Topic 409 - Capital Gains and Losses; March 2011