Understanding the tax implications of options and futures is essential for traders looking to maximize their returns and stay compliant with tax laws.
Governments worldwide require you to pay them a portion of your income through taxes, futures, and options; income is no different.
It’s important to know your instrument’s taxes, as different instruments have different tax implications.
Long and short options are subject to specific tax rules.
Exercising a long call option adds the premium to the stock cost basis, while short options are taxed as short-term capital gains or losses.
Complex strategies like straddles and spreads require careful tax management.
Futures profits are taxed under the 60/40 rule, with 60% long-term and 40% short-term capital gains.
As you can see, each strategy has its own rules, so knowing each rule can help you save in the long run.
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Taxes on Options Trading
To get started looking at potential tax implications, let’s start by looking at how options are taxed.
These rules apply to both calls and puts, and how they are traded will depend on how they are taxed.
Long Options
Long options are one of the simpler tax statuses to work with.
Below are some of the highlights on how they are taxed.
Holding Period: If a long option is held for less than a year, any gain will be classified as a short-term capital gain, usually taxed at a higher rate. If it is held for more than a year, it becomes a long-term capital gain, which is usually taxed at a lower rate.
Exercised Options: If you exercise a long option, the premium paid to purchase the option is added to the cost basis of the stock, deferring taxes until you sell the underlying. The tax on the underlying depends on how long you hold the stock, as mentioned above about the holding period.
Expired Options: If a long option expires unexercised, the resulting capital loss is classified depending on the holding period for the contract. A short holding period will result in a short-term capital loss, while a longer holding period means a long-term capital loss. Many governments treat these differently in terms of how they affect your income.
Short Options
Regardless of whether you are selling cash-secured puts or covered calls, all premiums received from these options will be considered short-term capital gains as long as the options expire or the position is closed.
Things get slightly tricky if the stock is assigned or exercised away.
For a covered call, if the stock gets called away, the premium is added to the sale amount and is taxed on the underlying stock’s cost basis and holding time.
If you are assigned stock due to a short put, then the cost basis for the actual stock is lowered by the premium you received.
Additionally, your holding period starts when you take possession (purchase) the stock.
Short options have a new layer of complexity to them, given that equity is potentially involved, which makes it extremely important to track your trades accurately.
Complex Options Strategies
Anything other than a simple long or short option will be considered complex for our purposes here.
This includes everything from a vertical spread through iron condors to ratio spreads.
Let’s start by looking at an options straddle as an example.
Straddles involve buying both a call option and a put option at the same strike price and expiration date.
This strategy is often utilized when a trader expects a lot of volatility but isn’t sure about the direction of the move.
Since both legs are long options, the tax treatment of options can differ based on the factors above in the Long Options section.
For instance, if the straddle is held for more than a year, it could be eligible for long-term capital gains treatment, but if it’s a short-term trade, it will most likely be treated as a short-term capital gain or loss.
Straddles are also subject to the Wash Sale rule, which is discussed further down.
Credit spreads are entirely different as they contain both a long and a short leg.
Options are not reported as the “net trade,” so each leg of the option is reported as an individual trade.
This will make your year-end reporting look different than what you expected.
However, you are still only paying gains or losses of the net position at year-end.
Consulting your Tax accountant or another tax professional is the best bet if you have specific questions about your particular trading strategy.
If you are a US resident, IRS Publication 550 has a lot of trading-related tax information.
Taxes on Index Options
Index options, like those based on the S&P 500, are typically taxed differently from regular stock options.
Under IRS Section 1256, they are considered “60/40” contracts, meaning 60% of gains or losses are taxed at the long-term capital gains rate and 40% at the short-term rate, regardless of the holding period.
These options are also subject to mark-to-market rules, which means they are treated as if sold at fair market value at year-end, making them ideal for traders looking to benefit from favorable tax treatment on short-term trades.
Taxes on Futures
Futures are taxed significantly differently than options are in the US.
Typically, futures profits are taxed using the 60/40 rule, where 60% of your gains are considered long-term capital gains and 40% are short-term, regardless of how long you hold the contract.
To many people, this makes them a superior trading vehicle because they have a built-in tax benefit.
Deeper Look at Taxes on Futures
Futures trading typically receives the favorable 60/40 tax treatment that was discussed above.
This approach, outlined under Internal Revenue Code (IRC) Section 1256, helps to prevent traders from manipulating their tax liability by shifting between short-term and long-term capital gains rates and ensures that they pay their “fair” share.
With that, there are some specific rules about futures accounting and taxes:
Mark to Market accounting requirement: All gains and losses on futures contracts are reported annually, using the fair market value on the last business day of the year, regardless of whether the positions were closed. This makes keeping records of trades vital.
Capital Gains Treatment: As discussed above, 60% of gains are considered long-term capital gains, while 40% are short-term. This is often seen as a benefit to the trader as short-term capital gains are taxed higher than long-term ones.
Loss Accounting: Futures trading losses are also treated more favorably than options. Futures trading losses can be carried back up to three years or carried forward if they exceed the carry-back limits. This helps offset prior and future income if you have an off year.
Strict Reporting: Where some options trades can be counted as ordinary income, all Futures need to be reported on a specific form in the US, IRS Form 6781.
This tax treatment offers more favorable conditions compared to other asset classes.
By understanding these rules, you can better manage your Futures investment strategy and optimize your tax obligations.
Straddle Rules: Options Vs. Futures
As mentioned, If you’re trading futures, you must report your gains and losses under the mark-to-market rules that apply to Section 1256 contracts.
This means that each year, your positions are treated as if they were sold for their fair market value, regardless of whether you sold them.
For these transactions, gains or losses are typically split between 60% long-term and 40% short-term capital gains or losses.
This unique tax treatment helps prevent the manipulation of derivatives for tax benefits.
Since both options and Futures are derivatives, placing a spread on the futures contract is also possible.
Since Futures contracts expire either monthly or quarterly, buying one month and selling another is possible.
These are very similar to the spreads you are used to on options in theory, but they behave very differently in practice.
They are also taxed differently.
Where complex options positions are subject to the Spread Rules, all of the items discussed above and futures are not subject to these rules.
It is possible to trade different futures spreads and still have them maintain the same favorable tax status.
Wash Sale Rules
Wash-sale rules are the next area that’s vital to understand for options and futures traders.
To understand how futures and options are taxed, you need to distinguish between the wash-sale rules that apply to options and the tax treatment of futures.
First, let’s look at what a wash sale is.
A wash sale is when you sell an option at a loss and then purchase the same or a substantially identical option within 30 days before or after the sale.
The IRS views this as a way to change your cost basis or tax loss harvest, and as a result, you can’t claim the loss. Since the loss is disallowed, the premium paid for the new option is added to its cost basis for tax purposes.
This rule guarantees you don’t manipulate your tax liabilities by repurchasing the same option quickly.
Now that you know what a Wash Sale is, it’s easy to explain how this affects the tax liability of different traders.
Wash sales apply to options and occasionally equities but not to futures.
This gives futures traders more freedom to open and close trades rapidly.
Do Taxes Affect Profits
Your tax burden from trading can have a sizable impact on your overall returns, so it’s important to know about potential tax treatment before you start to trade.
Futures contracts benefit from a favorable 60//40 tax treatment, which can greatly increase your after-tax returns, given the different possible tax rates.
On the other hand, options have more complex rules for reporting profits and losses, as well as how certain types of trades are taxed.
Additionally, holding periods and wash trade rules are something to be mindful of, as they can have serious tax implications and greatly reduce your after-tax returns.
One important thing to note about the tax effect, though, is that if you’re paying taxes, it means you are a profitable trader.
You can not “save yourself into a profit,” meaning that while taxes are important to know and understand, first and foremost, you should find a profitable trading strategy.
Jurisdiction, Businesses, and Tax Professionals
The tax laws written here are for the United States, and the IRS is constantly changing and updating US tax codes.
This means if your trading taxes are something you are concerned about or would like to have optimized, it’s best to see a tax professional, either an accountant or attorney, who would be better able to help with tax planning.
Additionally, many places tax capital gains differently, and countries occasionally offer tax breaks to break in new residents.
Puerto Rico did this after Hurricane Maria by offering a 0% capital gains tax on short- and long-term gains.
This just shows that sometimes location matters.
Lastly, your tax treatment could be different if you are trading through a business entity.
Many companies charge more for data to companies but so does the IRS.
Again, if you plan on trading for a living, a tax professional in your region would know your best plan.
Wrap Up
Taxes are a complex topic with an entire volume of information behind them, especially in the US.
Trades on Equities, Options, and Futures are treated slightly differently, which can profoundly impact your bottom line.
Knowing how each instrument is taxed and what rules apply can steer you to trade the best instrument for your desired outcome.
Remember that taxes only apply to the profitable trader, so work on profitability first.
We hope you enjoyed this article on the tax implications of options and futures.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Great info for everyone Gav. The only thing I would add is that one of the benefits of trading index options is that they are also taxed under the more favorable 60/40 rule.
That’s a good point, thanks for adding that