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Taxes on Stock Market Option Losses

Original post by Dan Keen of Demand Media

Just as there are stock market exchanges where stocks are traded, options exchanges handle the buying and selling of options contracts. As with stocks, not all options trades are successful, and some result in a loss. Losses, as well as gains, must be reported on your personal income tax return.

Options

Options are a way to leverage the buying and selling of stocks. An option is a contract that gives the holder the right, but not an obligation, to buy or sell a specific stock at a predetermined price on or before a certain date. One option contract controls 100 shares of the underlying stock.

A Sample Options Transaction

Suppose you buy a call option (costing $60) for the right to buy 100 shares of the XYZ Corporation at $30 per share within the next three months. The stock's current price is $29. You now have only $60 at risk, rather than the $2,900 that you would need if you bought the actual stock. If the stock doesn't go up to at least $30 within the three month period, you will let your option expire worthless. This would be a loss of $60, but that could be much less than the loss you might have taken had you purchased the stock and the price dropped.

When Options are a Loss

If an option is not exercised, it becomes worthless once the expiration date passes. The price you paid for the option, plus the commission fee, combine to yield the total loss. If you do exercise the option, it then has a zero value. Although the purchase price of the option appears to be a loss on paper, the $60 you spent now becomes part of the cost to buy the stock, namely $60 plus $3,000, or $3,060. Hopefully, you will eventually sell the stock at a price well below the cost to obtain it, and reap a nice profit.

Tax Reporting of an Options' Loss

Taxes on stock and option trades are reported on IRS Form 1040 Schedule D, "Capital Gains and Losses." The schedule provides columns to list each transaction's description, date purchased, date sold, cost, sale price and the profit or loss from the transaction (the sale price minus the cost). In the case of an option that is not exercised, the "sale price" is zero, and the "date sold" is the expiration date. If the option is exercised, the "sale price" would also be zero, and the "date sold" is the date it was exercised. As mentioned, this appears as a loss, though this loss may eventually lead to a gain if the underlying stock purchase proves fruitful. Once you buy an option you can sell it anytime before the expiration date, either for a loss or a gain.

Lmits on Losses

Generally, you can deduct capital losses up to the amount of your capital gains plus $3,000 (as of 2010). In some cases, you may be able to deduct additional losses in future years. If you find yourself in this situation, refer to the IRS's instructions for Schedule D, and consult a tax attorney to see if, and how, you can deduct all of your losses.

                   

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About the Author

Dan Keen is the publisher and editor of a county newspaper in New Jersey. For over 30 years he has written books and magazine articles for such publishers as McGraw-Hill. Keen holds a degree in electronics, was chief engineer for two radio stations and taught computer science at Stockton State College.

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