How Much Tax Do You Pay on Call Option Gains?

by W D Adkins

A call option is a derivative security, and the value of a call option depends on the value of some other security, such as shares of a company’s stock. Call options let you invest in the underlying security with a lot less money. For example, you might pay $2 per share to buy call options for a stock selling at $20 per share. Of course, if your investment produces a gain, the IRS will be there to collect their share.

Description

A call option contract entitles you to buy a specific amount of an underlying security. For stocks, this is usually 100 shares. You are guaranteed an exercise price for a limited time period called the expiry. You are not under any obligation to exercise the option to buy the underlying security, and you can let the call option expire unused. You’ll see call options trade on the Chicago Board Options Exchange and many other financial markets.

Cost Basis

You must pay a premium to the issuer of the call option, known as the option writer, to purchase the contract. In addition, when you trade options, you have the usual broker’s fees and transaction costs. When you exercise a call option, you must pay the exercise price. These expenses, added together, make up the cost basis or tax basis of the transaction. To calculate your taxable gain, subtract the cost basis from the total proceeds when you sell the underlying security. For example, if the cost basis for a call stock option is $25 per share, and you sell the shares for $35 per share, your taxable gain is $10 per share.

Tax Rates

Gains on call options are capital gains, and they are either short- or long-term capital gains. The determining factor is the length of time the capital asset is held. The time you held the option contract prior to exercise does not count. If, as is usually the case, you sell in a short period of time, you have a short-term capital gain. Short-term gains are taxed at the same rate as ordinary income, with a maximum rate of 35 percent as of 2011. If you choose to wait more than one year to sell, the gain is considered long term. In this case, your gain is taxed at a maximum rate of 15 percent.

Unexercised Options

To realize a gain, the price of the underlying security must rise above the exercise price before the expiry date. If that does not happen, the call options are worthless and you can let them expire. If this happens, the time you held the option contract matters. If you held the options one year or less, you have a short-term capital loss. If you held the option contract for more than one year, you have a long-term capital loss. You can use either to offset gains on your tax return.

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