Transaction examples
Refer to these examples to help you better understand option transactions.
The following tax codes can be used to recognize and categorize transactions associated with option events.
- 907 – Option - Open (Underlying asset held in account)
- 908 – Option - Open (underlying asset not held in account)
- 909 – Option - Open (reconcile cash balancing)
Basis and proceeds reporting for non-1256 options
It's important to understand the difference between purchased and written options.
For purchased options:
- The basis equals the amount paid including commission
- Proceeds equal the amount received net of commission
For written options:
- The basis equals 0
- Proceeds equal the premium net of cost to close
- Proceeds can be negative
While written option contracts appear to be like short sales, their treatment for reporting is different. When the option expires, the reported basis is always 0. The reported proceeds are the proceeds received at the time the contract was written minus the cost to close the option. This can be negative.
Write (sell) call option
In the following three scenarios the account writes (sells) a call contract. The creation and sale of the call option generates income to the account. This does not have tax consequences. The tax consequences of option activity are always determined by a subsequent event (for example, whether the option is bought back, expires unexercised, or is exercised).
Scenario 1: buy back option before it's expired or exercised
Tax treatment: If the writer of the call enters into a closing transaction (for example, they buy back the call option by payment of an amount equivalent to the value of the call at the time of such payment), the difference between the amount paid for the buying back of the call option and the premium received is a short-term or long-term capital gain or loss based on the holding period (the lapsed time from the creation of the call and the buyback).
Outline of events that make up this scenario:
- Account owns underlying stock (referred to as covered call)
- Account sells call option on underlying stock
- Account buys back the call option, closing the contract obligation, prior to the call being exercised and its expiration date
The trust purchased 1,000 shares of Apple at $410/share in January 2012. On April 9, 2012, with the stock at $639/share, the investment officer writes 10 calls (each call represents 100 shares). On Jan 2014, they buy back calls for $650 at $115 per share. Net income from the transaction after fees is $114,960.00.
Bridging the write option: Tax code 907 indicates that an opening option position has been taken in an underlying asset that the account holds in its portfolio. This is referred to as a covered call. If the account didn’t hold any shares of Apple, then this would be referred to as a naked call. Tax code 908 would be used for identifying the writing of naked calls.
For this scenario, there should be a transaction (record type 3) mapped to tax code 907 with a cash amount equal to the proceeds received (option price less brokerage fees = $114,960) with a posting date of 4/13/2012 (the date the cash was received and posted to the account) and a tax effective date of 4/9/2012 (the date the calls were written). This transaction has no tax consequence. The explanation of the transaction should contain details such as: “Sold 10 Apple w/call 01/2014 650 on 4/09/2012 at 115.00. Fees $40.00”.
Subsequent events
Example 1A
On Sept. 17, 2012, with Apple stock at $699/share, the investment officer buys back 5 calls at $130 for a net $64,978. The buying back of the call position is a closing event and triggers the taxable event.
For written options, the basis is always equal to zero. The proceeds equal the premium received when writing the option net of the cost to close. The proceeds can be negative when the cost to close the option exceeds the premium received when the option was originally written. In this example, there is a loss.
The premium received for writing the 5 calls is $57,480 ($114,960 times 5/10) and the cost to close the option is $64,978. To capture the tax consequences of the buy back of the 5 calls, a tax only sale should be bridged.
Key fields to be populated are:
- Record type 4 Transaction Amount (starting position 517) = ($7,498)
- Record type 4 Trade Date (starting position 290) = 20120917
- Record type 4 Portfolio (starting position 103) = 5 (tax impact only)
- Record type 4 Units Sold (starting position 501) = 5
- Record type 5 Federal Acquired Date (starting position 104) = 20120409
- Record type 5 Lot Units Sold (starting position 206) = 5
- Record type 5 Federal Cost Basis (starting position 222) = $0.00
The reportable federal gain/loss on this trade is ($7,498).
1099-B should report a cost basis of $0.00 and a short-term loss of $7,498.
Why is a tax only sale required? Normally the sale of an asset represents the receipt of cash into the account that directly impacts income or principal cash balance. But, in this case, part of the reportable proceeds was already posted to the account when the call was written on April 9, 2012.
This leaves the cash impact of buying back the calls on Sept. 17 to be accounted for.
Tax code 909 Option – Miscellaneous
can be used to reconcile cash balances. The reconciliation of cash would bridge as a Record 3, tax code 909, with the cash amount equal to the cost of buying back the 5 call options, a negative $64,978. (option price ($130 x 500) – brokerage fees ($22) = ($64,978). The use of tax code 909 has no tax consequence but is needed to recognize the cash consequences in the account. The transaction has a posting date of September 17, 2013, and a tax effective date of September 17, 2013 (the date the calls on the asset were bought back). The explanation of the transaction should contain details such as “Deliver – Buy to Cover and/or Option Trade to Close”. It should also include reference to the option to make the review and audit of the related transactions easier to identify. In this case, the suggested content would be “Buy to close January 5, 2014 650 calls on September 17, 2013 at $130.00”.Example 1B
On May 28, 2013, with Apple stock at $535/share, the investment officer buys back the remaining 5 calls at $42 per share, thus closing the remaining 5 calls that were originally bought on April 9, 2012. The net amount of the transaction is $20,980 (($42 x 500) - $20(fees)).
As in Example 1A previously, to capture the tax consequences of buying back 5 calls on May 28, 2013, a tax only sale should be bridged. The associated proceeds from the writing/creation of the options have already been credited to the account and bridged when the option was initially written/created back on April 9, 2012.
Key fields to be populated are:
- Record type 4 Transaction Amount (starting position 517) = $36,500.
- Record type 4 Trade Date (starting position 290) = 20130528
- Record type 4 Portfolio (starting position 103) = 5 (tax impact only)
- Record type 5 Federal Acquired Date (starting position 104) = 20120409
- Record type 5 Lot Units Sold (starting position 206) = 5
- Record type 5 Federal Cost Basis (starting position 222) = $0.00
The reportable federal gain/loss on this transaction is a gain of $36,500.
This leaves the cash impact of buying back the calls on May 28, 2013, to be accounted for. As mentioned previously in example 1A, tax code 909 should be used for reconciling cash balances for option transactions. The cash consequences are captured and bridged as a Record 3, tax code 909 with the cash amount equal to the cost of buying back the 5 call options (-$20,980). The transaction has a posting date of May 30, 2013(settlement date), and a tax effective date of May 28, 2013 (trade date), the date the asset (the calls) was bought back. The explanation of the transaction should contain details such as
Deliver – Buy to Cover and/or Option Trade to Close
.note
In this example, the holding period of the call position exceeds 1 year and is therefore reportable as a long-term gain.
1099-B should report cost basis of $0.00, and long-term gain of $36,500.
Scenario 2: option expires worthless
Tax treatment: If the writer’s obligation expires, the premium is a short-term or long-term capital gain to the writer upon such expiration based on the holding period from time of creation to the expiration date.
Outline of events that make up this scenario:
- Account owns underlying stock (referred to as covered call)
- Account sells call option on underlying stock
- Price of stock remains below the contract exercise price at the expiration date. Option expires worthless.
A worthless expiration occurs when the share price of the underlying stock falls or otherwise remains below the exercise price. The purchaser of the option doesn’t exercise their option prior to the expiration date, and on the expiration date the stock price is below the call price of the option.
The writer of the option retains the premium (money) that they received when the call was written. However, the option expiring worthless requires an additional record to be created (a sale transaction) to capture the tax consequences of the previous events.
The trust purchased 1,000 shares of Apple at $410 in January 2012. On April 9, 2012, with the stock at $639/share, the investment officer writes 10 calls (each call represents 100 shares). On Jan 2014 $650 calls at $115 per share. Net income from transaction after fees is $114,960.00 ($115 x 1,000 - $40 (fees).
At the time the calls are written, the tax consequence can't be determined but the receipt of cash into the account needs to be accounted for.
Bridging the write option: This transaction is bridged as a record type 3, using tax code of 907. Tax code 907 indicates that an opening position has been taken in an underlying asset that the account holds in its portfolio (covered call). The cash amount on the 907 transaction is equal to the proceeds received (option price – brokerage fees = $114,960). As in the previous example, this initial transaction has no tax consequence. The transaction has a posting date of April 13, 2012 (the date the cash is received and posted to the account) and a tax effective date of April 9, 2012 (the date the calls were created (position established)).
Subsequent event
During the life of this written call, it is never exercised and on the expiration date (the 3rd Friday of January 2014), the price of Apple never approaches within $50 dollars of the call exercise price of $650. The price of Apple closes at $594.57 and the call option expires worthless to the holder. Remember, the holder of the option had the right to purchase the 1,000 shares from the person who wrote the option for $650 a share at any time up until the expiration date of the option contract. At the expiration date, the option has no value in the market, therefore they shouldn't exercise the option by purchasing the shares at $650 from the option writer when the shares can be purchased on the open market for $594.57.
What is the tax consequence of the option reaching expiration and no exercise occurring? If the writer’s obligation expires through the passage of time, the premium is a short-term or long-term capital gain to the writer based on the holding period from time of creation to the expiration date. In this example, the writer of the option received a premium of $114,980 for offering to sell 1,000 shares of Apple for $650 at any time between when the contract obligation was created on April 9, 2012 and the call expiration date of January 17,2014. The holding period is long term as it exceeds 1 year. The proceeds received, the premium of $114,980, represents a long-term capital gain and the cost basis of the call obligation is zero. To capture the tax consequences of the call expiration event on January 17, 2014, a tax only sale should be bridged, since the associated proceeds from writing/creating the option of $114,980 has already been received and credited (booked) to the account when the option was initially written/created on April 9, 2012.
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Key fields to be populated are:
- Record type 4 Transaction Amount (starting position 517) = $114,980.
- Record type 4 Trade Date (starting position 290) = Jan 17, 2014
- Record type 4 Portfolio (starting position 103) = 5 (tax impact only)
- Record type 5 Federal Acquired Date (starting position 104) = 4/09/2012
- Record type 5 Federal Cost Basis (starting position 222) = $0.00
Why is a tax only sale required previously? Normally the sale of an asset represents the receipt of cash into the account. In this case, the proceeds for this tax event have already been posted and credited to the account when the call was written back on April 9, 2012. The bridged sale with a tax only portfolio value = 5 captures the tax consequence of the event, that is, the expiration of the calls at 0 value, and has no impact on the cash balance in the account.
1099-B should report a cost basis of $0.00 and a long-term gain of $114,980.
Scenario 3: option is exercised
The purchaser of the option exercises their right to purchase stock at the option call price prior to the expiration date.
Tax treatment: If the writer sells the underlying stock pursuant to the exercise of a call, the premium received by the writer increases the amount realized upon the sale of such stock in determining gain or loss. Such gain or loss is short-term or long-term depending upon the holding period of the stock. (The premium received is added to the amount received based on the exercise price to determine the proceeds amount and the realized gain/loss.)
Outline of events that make up this scenario:
- Account owns underlying stock
- Account sells call option on underlying stock
- Purchaser of the call option exercises their right to purchase stock at the call price prior to the expiration date
- Account needs to surrender underlying stock to the purchaser of the call option at the call strike price
The trust purchases 1,000 shares of Apple stock at $410/share on January 7, 2012. On April 9, 2012, with the stock at $639/share, the investment officer writes 10 calls (each call represents 100 shares). On January 2014 $650 calls at $115 per share. Net income from transaction after fees is $114,960.00 ($115 x 1,000 - $40 (fees).
At the time the previous calls are written, the tax consequence can't be determined but the receipt of cash into the account needs to be accounted for.
Bridging the write option: This transaction is bridged as a record type 3, using tax code of 907. Tax code 907 indicates that an opening position has been taken in an underlying asset that the account holds in its portfolio. The transaction amount would be set to equal the net cash received (option price – brokerage fees = $114,960). This transaction has no tax consequence. The transaction has a posting date of April 13, 2012(the date the cash is received and posted to the account) and a tax effective date of April 9, 2012(the date the calls were created (position established)).
Subsequent event
On Sept. 12, 2012, Apple stock reaches a price of more than $700/share and the holder of the 10 calls decides to exercise his option to buy 1,000 shares of Apple for $650/share. Remember, the holder of the option had the right to purchase the 1,000 shares from the person who wrote the option for $650 a share at any time up until the expiration date of the option contract.
The trust is obligated by the call contract to sell 1,000 shares of Apple at the strike price of $650. The cost basis of the sale is derived from the purchase price on January 7, 2012 at a net cost of $410,079. The tax consequences are captured in a sales transaction with a sales price of 1,000 x $650 = $650,000.
But how do we account for the premium we received for writing the call? If the writer sells the underlying stock pursuant to exercise of a call, the premium received by the writer increases the amount realized upon the sale of such stock in determining gain or loss. Such gain or loss is short-term or long-term depending upon the holding period of the stock. The premium received is added to the amount received based on the exercise price to determine the proceeds amount and the realized gain/loss.
The premium received by the writer net after fees was $114,960.00. This is added to the amount received from the underlying stock, $650,000, for a total sales price of $764,960. The holding period for the sale is based off the acquired date of the stock, Jan 7, 2012, and the stock trade date, September 12, 2012.
Key fields to be populated are:
- Record type 4 Transaction Amount (starting position 517) = $764,960.
- Record type 4 Trade Date (starting position 290) = 20120912
- Record type 4 Portfolio (starting position 103) = 2
- Record type 5 Federal Acquired Date (starting position 104) = 20120107
- Record type 5 Federal Cost Basis (starting position 222) = $410,079
The previous information meets the compliance reporting requirements for the sale but results in an overstatement of cash received. Since the premium received was posted to the account when the call was originally written on April 9, 2012, and then again included in the sales price of the underlying stock to meet the tax compliance reporting requirement, our cash balance, because of the double posting, is overstated by $114,960.
The bridge will need to include a tax code 909 (Option-Open (reconcile cash balancing) transaction with an amount of ($114,960). Tax code 909 is used to categorize option-related transactions to reconcile cash balances due to the manipulation of sales amounts required by the option rules.
1099-B should agree with the data on bridged sale. 1099-B should report a cost basis of $410,079 and a short-term gain of $354,881.