How Are Option Premiums Taxed When Bought or Written?

Option premiums are not taxed the moment money changes hands. The IRS treats each option as an open transaction and waits to see what happens: the contract either expires, gets sold or bought back, or is exercised. Only then does the premium turn into a taxable gain or loss, and the character of that gain or loss depends on which side of the trade you were on and what kind of option it was. Two statutes do most of the work. Section 1234 governs standard equity options, and Section 1256 sets a very different set of rules for broad-based index options.¹

When You Bought the Option

The premium you paid becomes your cost basis in the contract. Nothing is taxable at purchase. What happens next depends on how the position ends.

The Option Expires Worthless

If the contract expires without value, you have a capital loss equal to the premium. The loss is treated as if you sold the option on the expiration date.¹ Whether it is short-term or long-term follows how long you held the option itself.

You Sell the Option Before Expiration

Sell to close, and your gain or loss is the difference between what you received and what you originally paid. Buy a call for $500, sell it seven months later for $800, and the $300 gain is a short-term capital gain because you held the option less than a year.²

You Exercise the Option

Exercise is not its own taxable event. The premium folds into the stock transaction that results.³ Exercising a call adds the premium to the strike price to give you your cost basis in the shares: a $5 premium on a $100 strike call means you paid $105 per share for basis purposes. Exercising a put reduces your sale proceeds by the premium paid, so a $5 premium on a $100 strike put means you realized $95 per share. The gain or loss is calculated later, when you sell the underlying stock, and the holding period that matters is the stock’s, not the option’s.

When You Wrote the Option

Selling to open brings in premium, but you cannot recognize it right away. The tax result waits on how the contract ends.

The Option Expires Unexercised

This is the outcome many writers want, and the tax rule catches some of them off guard. When an option you wrote expires worthless, the entire premium is a short-term capital gain, no matter how long the contract was open.¹ Section 1234(b) treats the lapse of a written option as a sale of a capital asset held for one year or less. Even a 14-month LEAPS put that expires produces a short-term gain to the writer.³

You Buy the Option Back to Close

A writer can close by purchasing an identical contract. The gain or loss equals the difference between what you collected and what you paid to close. Collect $800, pay $500 to buy back, and you have a $300 gain. Pay $1,100 and you have a $300 loss. Under Section 1234(b), these closing-transaction results are also short-term.¹

You Get Assigned

If the option is exercised against you, the premium is not taxed on its own. It adjusts the underlying stock transaction. On a covered call, the premium is added to the strike to give total sale proceeds, so a $5 premium on a $100 strike call means you received $105 per share against your stock basis. On a cash-secured put, the premium reduces your cost in the shares you had to buy: a $5 premium on a $100 strike put gives a net stock basis of $95 per share. Because assignment turns the option into a stock trade, the holding period that decides short-term or long-term is the stock’s.

How Holding Period Determines the Rate

For most investors, options are capital assets, and their outcomes produce capital gains and losses rather than ordinary income. The exception is a dealer who trades options as part of a regular business.

Held one year or less, a gain is short-term and taxed at your ordinary income rate. Held longer than a year, it qualifies for long-term rates of 0%, 15%, or 20% depending on your taxable income.² Note that the short-term treatment written into Section 1234(b) means writers almost never see the long-term rate on premiums alone; the long-term rate becomes relevant when a premium adjusts a stock transaction and the stock itself was held long enough.

A separate surtax reaches many option traders. If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), a 3.8% Net Investment Income Tax applies on top of the regular capital gains rate.⁴ At the top of the schedule, that pushes the long-term rate to 23.8% and can drive the combined federal rate on short-term gains above 40%.

When an Option Changes Your Stock’s Holding Period

Two common strategies can quietly reset the clock on the stock underneath, and both matter because they can push a gain that you thought was long-term back into short-term territory.

Covered Calls

A covered call has to meet the Section 1092 test to be “qualified”: it is listed on a registered exchange, it has more than 30 days to expiration when written, it is not deep in the money, and you are not a professional options dealer. The definition of “deep in the money” varies with the stock price and time to expiration, which makes this rule tricky in practice. If the call qualifies, your stock’s holding period keeps running normally. If it does not, the IRS treats the position as a straddle and suspends the stock’s holding period for the entire time the call is open.⁵ Say you bought stock at $50 more than a year ago, it is now at $70, and you write a deep-in-the-money $50 strike call. The call is non-qualified, the stock’s clock freezes, and if you get assigned the $20 per share profit can be taxed short-term instead of long-term.

Protective Puts

Buying a put on stock you already own can also disrupt the holding period. The IRS generally treats the purchase like entering a short sale, and the effect depends on how long you have held the stock.³ Hold the stock a year or less when you buy the put, and the holding period resets to zero, staying there until the put is closed, exercised, or expires; then the clock restarts from scratch. Hold the stock more than a year first, and the put does not affect your holding period at all. Buy the stock and the put the same day (a married put), and the put also does not disrupt the clock. If you are close to the one-year mark on a stock with an unrealized gain, buying the put before that anniversary can erase your progress toward long-term status.

Wash Sales Involving Options

The wash sale rule disallows a loss when you buy a substantially identical security within 30 days before or after the sale that produced it, and the statute names options directly.⁶ Selling stock at a loss and then buying a call on that stock inside the window triggers the rule. Options themselves count as “stock or securities” for this purpose, so closing one option at a loss and opening a substantially identical one can also disallow the loss.

The disallowed loss is not lost. It shifts into the cost basis of the replacement position, deferring the loss until you close that trade, and the original holding period tacks on. Active writers who roll positions have to watch this carefully; closing a losing option and opening a similar one at a nearby strike or expiration can push losses into a later tax year without the trader realizing it.

Index Options and the 60/40 Rule

Options on broad-based stock indexes such as SPX, NDX, and RUT are taxed under an entirely different framework as Section 1256 contracts, and the treatment is generally friendlier than the equity option rules above.⁷

Not every option qualifies. Section 1256 covers “nonequity options,” meaning listed options that are not equity options. Options on single stocks and narrow-based ETFs like sector funds do not qualify. Options on broad-based indexes, regulated futures contracts, and foreign currency contracts do.

The 60/40 Split

Every gain or loss on a Section 1256 contract is split 60% long-term and 40% short-term, no matter how long you held the position.⁷ A three-day SPX trade and a six-month SPX trade get the same blended treatment. At the top federal rates, that produces a maximum effective rate of about 26.8% before the NIIT, compared to 37% on short-term gains from ordinary equity options. That rate spread is the main reason active traders gravitate toward index options.

Mark-to-Market at Year-End

Any Section 1256 position still open on December 31 is treated as if you sold it at fair market value on the last business day of the year.⁷ You report that paper gain or loss on the current year’s return and your basis resets to the year-end value, so only the change from that new basis flows through when you actually close. The 60/40 split applies to both realized trades and the year-end mark.

Three-Year Loss Carryback

Section 1256 also offers something regular equity options do not. A net Section 1256 loss can be carried back three years and applied against Section 1256 gains reported in those earlier years, potentially generating a refund.⁸ The carryback runs to the earliest year first, is capped by the Section 1256 gains in each prior year, and cannot create or increase a net operating loss. Corporations, estates, and trusts cannot make the election.

Where the Numbers Go on Your Return

Your broker reports closed positions on Form 1099-B, with sale date, proceeds, cost basis, and holding period for each trade.⁹ Where those numbers go next depends on which framework applies.

Standard equity options go on Form 8949, transaction by transaction, and the totals carry to Schedule D.¹⁰ When an option is exercised, do not report the option itself on Form 8949 at that point; the premium is already baked into the basis or proceeds of the stock trade, and the stock is what you report when you sell the shares. Basis adjustments from exercise and assignment are one of the most error-prone parts of option reporting, particularly when the 1099-B does not reflect the premium adjustment. If your broker does not report basis for older, non-covered positions, calculating it correctly is on you.

Section 1256 contracts go on Form 6781 instead.¹¹ Part I aggregates gains and losses, applies the 60/40 split, and produces a long-term figure and a short-term figure that transfer directly to Schedule D. The three-year loss carryback election is also made on Form 6781.

1
Office of the Law Revision Counsel. 26 USC 1234 – Options to Buy or Sell
2
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
3
Internal Revenue Service. Publication 550 – Investment Income and Expenses
4
Internal Revenue Service. Net Investment Income Tax
5
Office of the Law Revision Counsel. 26 USC 1092 – Straddles
6
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
7
Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market
8
Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles
9
Internal Revenue Service. Instructions for Form 1099-B
10
Internal Revenue Service. Instructions for Form 8949
11
Internal Revenue Service. About Form 6781, Gains and Losses From Section 1256 Contracts and Straddles