The Tax Treatment of Options Trading: An Updated Guide for 2025

So you've started trading options. You've bought some calls and puts in the past year and sold a few options, too. Now it's tax time, and you don't know where to begin.

You're not alone. As options trading steadily grows in popularity, more and more investors are curious about how to account for their trades when tax season rolls around. This guide provides the most up-to-date information on the tax treatment of options trading for the 2025 tax year, incorporating recent changes and offering practical tips to optimize your tax strategy.

The tax rules that govern options trading are a bit more complicated than those that govern equities trading. The Internal Revenue Service (IRS) has special rules for options trading. But the good news is that the tax rules that apply to options trading are commonsense, especially for investors familiar with paying taxes on their investments.

First, let's review how taxes work and discuss the type of tax levied on investors. Then, we can review how taxes are levied on buying and selling options and consider how to account for options that expire before they are used. Last, we'll discuss how the IRS taxes options on non-equities, including exchange-traded funds (ETFs) and futures.

A Brief Introduction to Taxes and Capital Gains

Taxes are fees that federal, state, and local governments levy against individuals and organizations that have received money from an activity. Although the U.S. tax code is complex and contains numerous loopholes and exclusions, you can be almost sure that the government will expect its cut when you come into money. As Benjamin Franklin famously quipped over 300 years ago, "In this world, nothing can be said to be certain, except death and taxes."

The type of tax that applies to options trading is primarily the capital gains tax. Capital gains taxes, which the federal government imposes, are levied on the difference between the amount an asset was sold for and the amount it was purchased for. For example, if you bought one share of an equity for $25 in January and later that year, in September, you sell the share for $40, a short-term capital gains tax would be levied on the $15 difference between the two amounts. Short-term capital gains taxes apply to assets that are bought and sold within 365 days, or one year. Long-term capital gains taxes, on the other hand, apply to assets sold over a year after being purchased.

Why does it matter if a capital gain is classified as short-term or long-term? For most investors, short-term capital gains tend to be taxed at a higher rate than long-term capital gains. While specific tax rates can vary, it's generally true that the more money you make, the higher your tax rate. To maximize profit, it's essential to remember the rate at which you will be taxed and plan accordingly.

Tax Rules for Option Buyers

So far, we've discussed how capital gains apply to the sale of equities. How do capital gains taxes apply to options? Let's keep it simple and discuss the taxes that apply to options on equities first. We'll get to taxes on non-equity options later.

First, remember that an option is a contract that gives a person the right, but not the obligation, to buy or sell a stock at a fixed price (called the strike price or exercise price) by a certain date (the expiration date or exercise date). There are two types of options: calls and puts. If an investor buys a call, they can buy 100 equity shares at the strike price before the expiration date. If an investor buys a put, they have the right to sell 100 shares of equity at the strike price before the expiration date. For the privilege of having a call or put option, the buyer pays the seller a fee, called the premium. (Want to learn more about getting started with options trading? Check out our article on Getting Started with Options Trading.)

There are essentially two outcomes when you buy an option: you either exercise the option (that is, you buy or sell shares of an equity at the strike price) or let the option expire. What you choose to do with the option will affect you at tax time.

Here are the tax rules for buying calls:

⚡ If you exercise the call and buy the shares at the strike price, and later sell the shares, you will be taxed on the cost of the call (the premium and any transaction costs) plus the amount you paid for the shares. The holding period of the shares determines whether it's a short-term or long-term capital gain. Holding the shares for over a year before you sell them is considered a long-term capital gain; if you have them for less than a year, it's regarded as a short-term capital gain.

⚡ If you exercise the call and keep the shares, you will not be taxed at the time of exercise, as capital gains taxes are only applied after shares are sold.

⚡ If you let the call expire without exercising it, the cost of the call (premium plus any transaction costs) is reported as a capital loss. This loss is typically a short-term capital loss, regardless of how long you held the option.

Here are the tax rules for buying puts:

⚡ If you exercise the put and sell your shares at the strike price, you will be taxed on the amount of the sale of the shares minus the cost of the option. Whether you will be taxed at a short-term or a long-term rate depends on how long you held the shares.

⚡ If you let the put expire without using it, the cost of the put is reported as a capital loss. This loss is typically a short-term capital loss.

Tax Rules for Option Sellers

For every call and put purchased, a seller (also referred to as the writer) has an entirely different strategy than the buyer. For example, while the buyer of a call hopes that an equity's share price will rise, the seller hopes for the opposite (or, at least, for the share price to remain roughly the same).

After the seller sells an option to a buyer, two things could happen: the buyer will exercise the option or let it expire. What the buyer does determines how the seller will be taxed.

Here are the tax rules for selling calls:

✅ If the buyer of the call exercises the option, you, the call seller, are obligated to sell the shares of the optioned stock. You will be taxed on the amount you received from the sale of the shares plus the premium the call buyer paid you. How long you held the stock before selling the option will determine whether you pay long- or short-term capital gains.

✅ If the buyer of the call never exercises the option, you, the call seller, will report the premium received as a short-term capital gain, regardless of how long you owned the stock.

Here are the tax rules for selling puts:

✅ If the buyer of the put exercises the option, you, the seller, must buy shares of the optioned stock. You will be taxed on the amount of the sale of the shares minus the premium the put buyer paid you, whenever you ultimately decide to unload the shares. Your tax rate will be determined when you choose to sell the shares (within a year, after a year?).

✅ If the buyer of the put never exercises the option, you, the seller, must report the premium received as a short-term capital gain.

Tax Rules for Options on Non-Equities (Section 1256 Contracts)

So far, we've discussed the tax rules that apply to the optioning of equities. Equities are shares that confer the holder partial ownership in a company. The IRS treats optioning non-equities, such as broad-based index options, futures options, and certain commodity and volatility ETFs/ETNs, differently. These are generally classified as Section 1256 contracts [1].

According to IRS Code Section 1256, taxes on options trading of non-equities are subject to the 60/40 rule, which stipulates that 60% of capital gains are long-term and 40% are short-term, regardless of how long an option is held [2]. This can be a significant tax advantage for traders, as a larger portion of gains is taxed at the lower long-term capital gains rates. Section 1256 contracts are also exempt from wash sale rules and the $3,000 capital loss limitation, offering further benefits for active traders [2].

Trader Tax Status (TTS) and Business Expense Deductions

Qualifying for Trader Tax Status (TTS) for highly active options traders can provide substantial tax advantages. Traders eligible for TTS can deduct business expenses on Schedule C of their tax return, and may qualify for the Section 475 mark-to-market (MTM) accounting election [2].

Key TTS qualification factors generally include:

✅ Trade Volume: A minimum of 720 trades annually.

✅ Frequency and Holding Period: Trading activity on 75% of trading days, with an average holding period of 31 days or less.

✅ Time Spent: More than four hours daily engaged in trading-related activities.

✅ Intent and Operations: Operating to make a living from trading.

If you qualify for TTS, you can elect Section 475 MTM, which exempts securities from wash sale rules and the $3,000 capital loss limitation. This election must be made by April 15th of the tax year it applies (e.g., April 15, 2025, for the 2025 tax year) [2].

Qualified Business Income (QBI) Deduction

Under the Tax Cuts and Jobs Act (TCJA), TTS traders may qualify for a 20% deduction on Qualified Business Income (QBI) derived from Section 475 trading gains. However, this deduction is subject to income limitations and will be phased out for married filers with taxable incomes above $383,900 and single filers above $191,950 in 2024 (these figures are subject to annual adjustment) [2].

Key Takeaways for the Options Trader

Understanding the tax treatment of options trading is crucial for minimizing tax liability and ensuring compliance with IRS regulations. Here are some key takeaways:

✅ Know Your Contract Type: Differentiate between equity options and Section 1256 contracts, as their tax treatments vary significantly.

✅ Consider Trader Tax Status: If you are an active trader, explore whether you qualify for TTS and the Section 475 MTM election to unlock potential tax benefits.

✅ Track Your Trades Meticulously: Accurate record-keeping is essential for reporting gains and losses correctly, especially with wash sales and complex options strategies. Tools like TradeLog can assist with this [2].

✅ Plan for Tax Efficiency: While tax reduction shouldn't be your sole trading goal, consider the tax implications of your strategies. For example, holding an asset for over a year can shift gains from short-term to long-term rates.

✅ Consult a Professional: The tax landscape for options trading can be complex. Always consult a qualified tax professional to optimize your tax situation and make informed decisions.

For further reading on the broader implications of tax laws on trading, consider these external resources: Investopedia: Tax Treatment for Call and Put Options and SmartAsset: How Options Are Taxed

This blog post is for educational purposes and does not constitute tax advice. Always consult a qualified tax professional for personalized guidance.

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