Taxation Of Options and Convertible Securities
An option gives the holder the right to purchase property at a specified price that is good until a certain date — the expiration date. If the option is not exercised before the expiration date, then it ceases to exist, it becomes worthless. The person who grants the option is known as the option writer or grantor, while the person who receives the option in exchange for a payment — the premium — is the option holder, or grantee.
The most common types of options are options on securities or indexes. A call is a type of option that gives the holder the right to purchase securities at a specified price, called the strike price, until the expiration date. The call writer is the one who grants the option in exchange for the premium. A put is an option giving the holder the right to sell a specified security to the put writer for the strike price, in exchange for the premium. The put writer grants the option and, in exchange, receives a premium. The option price depends on the price of the underlying asset, the strike price, the volatility of the underlying asset, and the term of the option.
How an option is taxed depends on whether the taxpayer is the writer or holder of the option. The option writer does not realize a profit or loss until the option contract is terminated. For options on securities, commodities, or commodity futures, any gain or loss by the option writer who is not a dealer in options is short-term. Gains on options on any other type of property results in ordinary income to the grantor when the option expires. When an option holder sells an option or if the option expires, then it is a long-term capital gain or loss if the option was held for more than 1 year; otherwise it is a short-term capital gain or loss. However, most options have a term of less than 1 year, so most gains or losses are short-term, which are subject to ordinary income tax rates.
Options on regulated futures contracts — futures options — such as the S&P 500 futures, or options on broad-based indexes, such as the S&P 500 stock index (SPX), are considered Section 1256 contracts, in which 60% of any gains are treated as long-term capital gains or losses, regardless of how long the option was held. For tax purposes, these contracts are marked to market at the end of the year, so profits or losses must be reported for that year, even if the position remains open in the following year.
The tax treatment of an option also depends on how it is terminated. There are 3 ways to terminate an option. A common method is that the option writer can engage in a closing transaction by purchasing an option with the same characteristics that he wrote, thereby canceling his obligation on the contract. An option holder can close the transaction by selling the option on an exchange.
When an option holder closes a transaction, then there is a capital gain or loss if the underlying asset is a capital asset; otherwise, it is an ordinary gain or loss. If the holder held an option for a capital asset for longer than 1 year, then the closing transaction will be a long-term capital gain or loss; otherwise, it is short term.
The 2nd method by which an option may be terminated is through expiration. If the underlying asset fails to reach the strike price, then the option will expire worthless to the holder. In fact, most options do expire worthless. When an option expires, then the option writer must recognize the value of the premium as a short-term capital gain, regardless of how long the option contract was in existence. The holder of the option has a loss of the amount of the premium paid, and whether the gain or loss is a capital gain or loss depends on the asset class of the underlying asset and whether it is long term or short term depends on how long the option holder owned the property.
The other method by which an option terminates is through its exercise by the holder. The exercise of an option is not a taxable event, but it does change the profit or loss when the underlying asset is bought or sold. When a call is exercised, the call writer must sell the underlying asset to the call holder for the strike price. Hence, the call writer must add the premium received for the call to the gain or loss of the underlying asset that was sold to the call holder. The call holder adds the call premium to the basis of the stock, so if the call holder paid $1,000 for the stock by exercising the call, for which the holder paid a $100 premium, then the call holder's tax basis in the stock is $1,100. When a put is exercised, the put writer must buy the underlying asset from the put holder for the strike price. The put writer must subtract the put premium from the basis of the underlying asset and the put holder subtracts the put premium from the sale proceeds of the underlying asset. So if the put writer received $100 for the premium and paid $1,000 for the underlying stock because of the exercise of the put, then the tax basis in the stock is $1,000 – $100 = $900. If the put writer later sells the stock for $2,000, then taxes must be paid on $2,000 – $900 = $1,100. Thus, taxes on the put premium are only paid when the received stock is sold. On the other hand, the put holder can subtract the $100 paid for the put premium from the $1,000 received for the stock that was sold to the put writer, so the put holder must report $900 of the stock proceeds as income.
- Case 1: Call writer sells 10 covered calls for $400, with a strike price of $10 per share. The call writer paid $7,000 for the 1,000 shares of the underlying stock. (Note: each stock option is standardized for 100 shares of stock.)
- The call holder exercises her 10 calls by paying $10,000 to the call writer for the stock.
- Tax result: The call writer recognizes a profit of $10,000 – $7000 = $3000 + $400 for the call premium = $3400. The call holder has a tax basis in the purchased stock of $10,000 – $400 paid for the call premium = $9600.
- Case 2: Same as Case 1, but the calls expire. The call writer recognizes a short-term capital gain of $400 for the call premium. The call holder recognizes a $400 loss, which will be a long-term loss if the holder held the calls for more than 1 year; otherwise, it is a short term loss.
Puts used to hedge a position receive special treatment under tax law. If the buyer of a put also owns the underlying asset, then it may be treated as a short sale if the put is either exercised or expires, in which case it will be treated as a closing of a short sale. However, the short sale rules will not apply if the stock was held long-term and if the put was purchased on the same day and identified as a hedge on the stock — this is sometimes called a married put and stock.
When a convertible bond or a convertible preferred stock is converted into the common stock of the same corporation, then no gain or loss is recognized as long as the conversion feature was one of the characteristics of the bond or preferred stock when it was purchased.
The tax basis of the converted stock is equal to the tax basis of the convertible security. However, if there is a cash payment that is required for the conversion, then both the holding period and the tax basis of the acquired stock must be apportioned between the portion attributed to the original purchase of the convertible security and the cash paid for the conversion to stock.
Example: On January 5, 2015, you buy a $1000 convertible bond that can be converted into 5 shares of common stock. The holding period for the bond begins the day after the purchase, or January 6. On June 1, 2017, you convert the bond into stock and sell the stock for $1500. Your holding period for the stock begins on the day after when you first purchased the convertible bond, on January 6, 2015. Therefore, your gain is long-term. The tax basis of your stock is $1000, and since you converted the bond into 5 shares, each share has a tax basis of $200. Therefore, your profit per share is $100, for a total of $500.
Case 1: Same as the above example, but you pay $100 for the conversion. Your tax basis in your 5 shares of stock is $1000 + $100 = $1100, so the basis for each share is $1100/5 = $220. Since the cash payment of $100 is 10% of the original tax basis of the convertible bond, 90% of the profit is long-term capital gain, while the remaining 10% of the profit is short-term capital gain attributed to the cash payment.
The conversion of the bond to the common stock is not a taxable event, regardless of the fair market value of the stock when the conversion takes place. However, although a bondholder can choose either to amortize a premium paid for a bond or to add it to its basis, no amortization is allowed for that part of the premium that was paid for the conversion feature.
Beginning in 2014, brokers are required to report, on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, the cost basis of any options or bonds purchased in 2014 or thereafter. However, the taxpayer must maintain records of options or bonds that were purchased before 2014.