The Tax Policy on Options Trading on a Loss

by Eric Bank Google

    It's easy to lose money on options -- people do it every day. Calls and puts give buyers the right to purchase or sell, respectively, an underlying asset at a specified price -- the strike price -- on or before an expiration date. An option seller collects a premium and must stand ready to buy or sell the underlying asset if a buyer exercises the option. The timing of option trading losses depends on the circumstances surrounding the loss.

    An option can lose all of its value by expiration. The option buyer shoulders this loss, which is equal to the original premium paid to a seller plus commissions. If the buyer owned the option for more than a year before expiration, it's a long-term capital loss; otherwise, it's a short-term loss. The buyer usually recognizes the loss in the year the option expires. Capital losses offset capital gains and up to $3,000 of ordinary income. Short-term losses first offset short-term gains, then long-term ones. The reverse is true for long-term losses. You can carry over excess capital losses to future tax years.

    To avoid a total loss, you might want to dispose of a losing option before it expires. If you own the option, you offset it by selling an identical option. Option sellers offset their position by buying an identical option. The two options cancel each other out, and the net loss is the excess of the option purchase cost over its sale proceeds. An option buyer may have a long- or short-term capital loss. The seller's capital loss is always short term.

    When a buyer exercises a call or put, the seller will be assigned to sell or buy assets, respectively, at the strike price. For calls, the buyer adds the option premium to the strike price to figure his cost basis. The buyer does not recognize a gain or loss until eventually selling the underlying asset. The call seller adds the option premium to the strike and subtracts the asset's cost basis to figure the immediate gain or loss. For puts, the buyer sums the asset's basis and the put premium, then subtracts the strike to get the immediate gain or loss. The put seller subtracts the put premium from the strike to get the asset cost basis, but only realizes a gain or loss later, when selling the underlying asset.

    Straddles are offsetting transactions that reduce risk -- a form of hedging. For example, if you own 100 shares of stock, you can grab a put on the stock for downside protection. The Internal Revenue Service presides over a rat's nest of tax rules regarding straddles. In some cases, you must defer your loss on the disposed -- offset or expired -- option portion of a straddle until you later dispose of the underlying stock or other asset. In this case, your loss might span two years if you hold the underlying asset into the next year. In the year you dispose of the option, you can only recognize a loss exceeding the unrecognized gain on the underlying asset at its year-end value. You can recognize the remaining loss in the next tax year. Straddles come in many flavors, so check the tax rules in IRS Publication 550 to understand the rules that apply to your situation.

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    About the Author

    Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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