If you trade in options -- securities that offer the ability to buy or sell a stock at a particular price -- you may be surprised when it comes to tax season. Purchases and sales of options are not reported on your 1099 forms along with your other investment income. This does not mean, however, that you do not have to report income earned through such trades on your annual tax return.
Reporting Gains from Options Trades
If you buy an option and sell it at a later date for a profit, you have realized a capital gain. This gain is taxable at either long-term (more favorable) or short-term rates, depending on how long you held the option before you sold it. Options held for longer than one year are considered long-term, anything less is short-term. If you lose money on the transaction, you have a capital loss, and you can use this to offset your gains for the year. Both transactions are reported on Schedule D of the 1040 form. Note that if you practice "straddling," or using equal and opposite option positions to limit your risk of loss, the tax rules change significantly. The IRS recommends that people using straddles see a professional tax preparer to review the tax implications of this practice.
Expired and Executed Options
If you allow an option to expire, the value of the premium you paid to acquire the option is now lost. You can report this loss on Schedule D of your 1040 form and use it to offset your gains for the year. If you execute an option, the value of the premium is added to the cost basis of the purchased stock. This lowers the amount of capital gain you receive when you sell the option in the future. You do not have to report the purchase or exercise of an option -- all tax obligations are attached to the gain at the time of sale.
If you write puts or calls, the premium you receive from the option buyer is only reportable once the option is exercised, is closed or expires. If the option is executed, the premium is added to the cost of buying or selling the stock and factored in to any resulting gain or loss. If the option is closed or expires, the premium is recognized as your short-term gain at that time, regardless of how long the option was open.
If you trade trade frequently enough to be considered a trader by IRS standards, gains and losses related to options transactions become business income and expenses and are taxed differently. See an accountant if you make short term trades (of any type) several times per week, or if you qualify as a pattern day trader under FINRA regulations. Whether or not you are a day trader, you will need to pay estimated income taxes or increase your payroll withholding during the year if your trading activity yields over $1,000 in income tax.