How Stock Options Are Taxed

by Tax Guy - Burlington Accountant on September 23, 2009 Print This Post Print This Post

This is the final article in my series on stock options. The previous articles provided background on what stock options are and how stock options are used. In this article, I address the tax consequences of using stock options.

Capital Gains or Business Income?

The first step in figuring out how stock options are taxed is to determine whether your gains or losses are capital gains and losses or business gains and losses.

Only 1/2 of capital Gains are taxed while businesses can deduct expenses from income but the net income is taxed at your marginal tax rate.

For more information on capital gains, see Capital Gain or Income?, Calculating Gain or Loss on a Stock Sale, and Superficial Losses: Gains & Loss on Identical Properties.

Buying or Holding Call Options

If you have purchased or hold a call option, you have acquired the right to buy a stock at the stated price on or before the option expires.

You expect the share price to rise before the option expires so that you can either “lock in” the share price or sell the option on the options exchange before it expires.

If the option expires, you will be out of pocket for the price of the option.

  Capital Income
Exercising A Call Option The costs of the option plus brokerage fees is added to the adjusted cost base of the shares. The costs of the option plus brokerage fees are added to the cost of the shares.
Call Option Expires The cost of the option plus brokerage fees become a capital loss in the year the option expires. The cost of the option plus brokerage fees is deducted from income in the year the option expires.
Selling or Closing The Option The adjusted cost base of the option is deducted from the selling price less brokerage fees generate a capital gain or loss. The premium is added to income while the cost is deducted from income.

Buying A Put Option

If you have purchased a put option, you are acquiring the right to sell a stock at a stated price on or before it expires.

You expect the price of the stock to fall before the option expires so that you can “lock in” your gains.

If the option expires, you will be out of pocket for the price of the option.

  Capital Income
Exercising A Put Option The cost of the put plus the brokerage fees is deducted from the proceeds from the sale of the shares. The cost of the put plus the brokerage fees is deducted from the proceeds from the sale of the shares.
Put Option Expires The cost of the option plus brokerage fees become a capital loss in the year the option expires. The cost of the option plus brokerage fees is deducted from income in the year the option expires.
Selling or Closing The Option The adjusted cost base of the option is deducted from the selling price less brokerage fees generate a capital gain or loss. The premium is added to income while the cost is deducted from income.

Selling A Call Option

The seller of a call option has an obligation to sell or deliver shares of a stock at a stated price on or before the option expires.

If you are selling or writing a call option, you believe the price of the stock will not change or will decrease so that you can earn a premium.

Covered Call – If you own the share and the price increases and the option is exercised then you must deliver your shares to the other party.

Naked Call Option – If you do not own the shares and the option is exercised you will have to purchase the shares on the stock market to deliver.

Selling/Writing Covered Call Options*

  Capital Income
Premium The premium less brokerage fees is a capital gain when written. The premium is included in income when the option is exercised.
Exercised Call Option The premium is added to the proceeds of the share sale (If written the in the prior year, you’ll need to amend your tax return for the prior year to remove the gain). The premium is included in income when the option is exercised.
Call Option Expires The premium less brokerage fees is a capital gain when written. The premium is included in income when the option expires.
Selling or Closing The Option The premium less brokerage fees is a capital gain when written and an offsetting position would be deducted from the capital gain. The premium is income and the cost of the offsetting position is a deduction.

* Gains and losses on the writing of naked (non-covered options) are typically considered income.

Selling A Put option

The seller of a put option has an obligation to buy a stock before the option expires.

Selling/Writing Put Options

  Capital Income
Exercising A Put Option The premium is subtracted from the adjusted cost base of the shares. The premium is subtracted from the adjusted of the shares.
Put Option Expires The premium less brokerage fees is a capital gain when written. The premium is included in income when the option expires.
Selling or Closing The Option The premium less brokerage fees is a capital gain when written and an offsetting position would be deducted from the capital gain. The premium is income and the cost of the offsetting position is a deduction.

More Information On Investments

If you are looking for more information on the types of investments available and how they work, take a look at the Investor Education Fund.

About The Tax Guy...

Dean Paley CGA CFP is a Burlington accountant and financial planner who services individuals and business owners locally, nationally and internationally. Dean has appeared in the National Post, Toronto Star and Metro News.

To find out more, visit Dean's website Dean Paley CGA CFP or connect via Twitter @DeanPaleyCGACFP.

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{ 12 comments }

Bits September 23, 2009 at 3:13 pm

Very nice article!

Just wanted to clarify one thing. For covered call writing, why are gains and losses typically considered income? Under what conditions, if any, are they considered capital gains? I can see how options would not qualify as capital gains because of their short periods of ownership, but is this criterion not applicable for options since they have an expiry date?

Thanks.

Tax Guy September 23, 2009 at 7:05 pm

@ Bits

The writer of Naked (non-covered) is normally income. The asterix note had text missing when the article was uploaded. It’s all fixed now.

Thanks!

J January 29, 2010 at 8:21 pm

Suppose I sell a covered call option in 2009 and buy to close in 2010. I assume the premium is considered a capital gain in 2009. But is the price paid to close the position a capital loss for 2010, or would I need to amend my 2009 tax return to reduce 2009 capital gains?

Tax Guy January 31, 2010 at 8:28 pm

@J – Assuming you normally trade on the capital account, the premium received in 2009 would be a capital gain. You would only amend your 2009 return if the option were exercised in 2010. If you acquire an offsetting option in 2010, the cost would be a capital loss in 2010.

Marin February 15, 2010 at 10:59 am

Clear and concise.
Considering you are treating all premiums received as Income,
I found out that you should use form 2125.
What Part should I use to include that income, Part 1, business Income, Part 2, Professional Income? If for the year in question there is a net loss, what Part should we use to deduct income given the net loss from option writing.
Thanks in advance tax guy.

Tax Guy February 15, 2010 at 8:07 pm

I have not had to complete forms for options trading on the income account. However, if you normally treat your gains and losses as capital gains and losses but have options that require you to report your gains as income, you can report them as other income on Schedule 4. If you are considered in the business of trading then you can use the Business income form (T2124).

JL April 4, 2010 at 11:41 am

I normally treat my gains and losses as capital gains, but this year I wrote and bought back some naked puts as well. I sometimes made a profit, and sometimes made a loss, but eventually ended up with a total income loss (considering only those naked puts). How should this information be entered within Schedule 4?

Some choices :
a) report the total income loss as a “negative other investment income” (line 121);
b) report the total income loss as a deduction (line 221);
c) report separately all the income gains on line 121 and all the income losses on line 221;
d) other?

What do you think? Thanks for any pointers…

Tax Guy April 5, 2010 at 11:19 am

JL:
I would be inclined to report your gross gains as income on 121 and your gross losses on 221 and attach a letter to your return outlining how you have filed.

I would suggest that you should probably hire someone to do your taxes. You will have a reasonable assurance it was done correctly and you will have recourse if not.

The information in this site is general information only and should not be considered tax advice.

Shin December 7, 2010 at 9:13 am

Hi Tax Guy,

These are similar questions as Marin but I am asking about short put. For example, I short put a stock XYZ this year, I gain premium $100 and assume the premium is considered a capital gain in 2010. Here are my questions,
1) I close the position in year 2011 and pay $25,
2) I close the position in year 2011 and pay $200,
Should I consider capital loss $25 and $200 in year 2011 respectively? Or should I amend 2010 tax return for both cases?
Thank you

Tax Guy December 8, 2010 at 1:08 pm

I’m confused by your statements. On the one hand you say you are receiving the premium (which suggests you are writing the put) on the other you are paying out. Also, the concepts are a little confusing because the term “shorting” means to sell stock you don’t own.

Using the property terminology, please advise whether you are buying a put or writing a put.

The buyer of a put has the “right” to sell a security. The writer has an “obligation” to buy a security and receives the premium.

Shin December 8, 2010 at 1:28 pm

Thank you for your reply, let me clear my question,
I am writing the put to gain the premium ($100) on 2010, the expiry date is on May 2011. Let’s say today is Feb 2011, i want to close the position, therefore i need to pay the premium back to complete this trade, correct? IF the amount i am paying is $25, should this consider as my Cap lost on 2011? Or this is amend 2010 tax return ?
Thank you again

Tax Guy December 9, 2010 at 11:53 am

Writing a put means you are assuming an obligation to buy the underlying security in return for a premium.

You have said you normally trade on the capital account.

The premium received is a capital gain at the time the option is written.

If you acquire another option to close out the position, this is a capital loss.

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