Taxation of Equity Options Flashcards
A customer buys 1 ABC Jul 45 Call @ $5. The customer lets the contract expire when the market price is $40. Which statement is TRUE?
A. The customer has a capital loss of $500
B. The customer has a capital loss of $4,000
C. The customer has a capital loss of $4,500
D. The customer has a capital loss of $5,000
The best answer is A.
If the holder of an option contract allows the option to expire, he or she has a capital loss equal to the premium paid as of the expiration date.
A customer buys 1 ABC Jul 50 Call @ $4. The customer lets the contract expire. Which statement is TRUE?
A. The holder has a $400 capital loss as of the date the contract was purchased
B. The holder has a $400 capital loss as of the date the contract expires
C. The holder has a $5,400 capital gain as of the date the contract was purchased
D. The holder has a $5,400 capital loss as of the date the contract expired
The best answer is B.
If the holder of an option contract allows the option to expire, he or she has a capital loss equal to the premium paid as of the expiration date.
A customer buys 1 ABC Oct 75 Call @ $4 and exercises the contract. What is the cost basis for tax purposes?
A. $71
B. $75
C. $79
D. $80
The best answer is C.
When a call contract is exercised, the customer is buying the stock. The customer establishes a cost basis equal to all monies paid for the stock - $75 per share strike price plus $4 per share paid in premiums equals a $79 per share cost basis. Notice that the basis is the same as the breakeven.
A customer sells 1 ABC Jan 50 Call @ $3 when the market price is $51. The customer is exercised when the market rises to $53. The tax consequence is a:
A. $300 capital gain
B. $300 capital loss
C. cost basis of $5,300
D. sale proceeds of $5,300
The best answer is D.
When a call is exercised, the writer is selling the stock (no taxable event occurs until those shares are bought). The call premium received is considered to be part of the sale proceeds of the stock sale. For tax purposes, the customer is selling the stock at the strike price + call premium received ($50 + $3). Notice that this is the same as the breakeven.
A customer is short 1 ABC Jan 90 Call @ $5. The call is exercised when the market price of ABC is $100. The sales proceeds of the shares is:
A. strike price minus premium
B. strike price plus premium
C. market price minus premium
D. market price plus premium
The best answer is B.
If a short call is exercised, the writer is selling the stock at the strike price ($90). Since $5 per share was received in premiums, the writer’s sales proceeds is $95 per share for tax purposes. Note that this is the same as the breakeven on the position, which is the strike price plus the premium.
A customer buys 1 ABC Jan 35 Put @ $6 when the market price of ABC is $34. The put is exercised when the market price is $29. The tax consequence is a:
A. cost basis of $2,900
B. sale proceeds of $2,900
C. cost basis of $4,100
D. sale proceeds of $4,100
The best answer is B.
When a put is exercised, a holder is selling the stock at the strike price. The premium paid for the put reduces the sale proceeds. The stock is being sold at $35, but since $6 was paid in premiums, the net sale proceeds are $29 per share or $2,900 for the contract. Note that this is the same as the breakeven point.
A customer buys 1 ABC Jan 60 Put @ $5 when the market price of ABC is $58. The put is exercised when the market price is $51. For tax purposes, the sale proceeds are:
A. $4,600
B. $5,500
C. $6,000
D. $6,500
The best answer is B.
When a put is exercised, a sale takes place. The holder is selling for $60, but paid $5 in premiums, for a net sale price of $55 per share or $5,500 for the contract.
A customer has written 1 ABC Jan 40 Put @ $3. The contract is exercised when the market price is $32. The tax consequence to the writer is a:
A. cost basis of $3,700
B. sale proceeds of $3,700
C. cost basis of $4,300
D. sale proceeds of $4,300
The best answer is A.
If the writer of a put is exercised, he must buy the stock at the strike price. The premium received is a reduction of the cost of buying the stock. The writer of the put must buy 100 shares at $40 ($4,000), but he or she received $300 in premiums for writing the contract, so the adjusted cost basis is $3,700 for 100 shares.
A customer sells 1 XYZ July 60 Call @ $4 after having purchased 100 shares of XYZ @ $55 per share. If the customer is exercised, the tax consequences are:
I cost basis of $55 per share
II cost basis of $59 per share
III sale proceeds of $60 per share
IV sale proceeds of $64 per share
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
The customer purchased the stock at $55 for a cost basis of $55 for tax purposes. When the call is exercised, the customer must sell the stock at the strike price of $60. Since the customer also received $4 in premiums from the sale of the call, this is included in the sale proceeds for tax purposes. The sale proceeds are thus $60 + $4 = $64 per share. The net taxable gain is: Cost Basis of $55 - Sale Proceeds of $64 = Taxable Gain of $9 per share.
A customer buys 100 shares of XYZ stock at $51 and buys 1 XYZ Jan 50 Put @ $4 on the same day. The put expires and the stock is sold in the market for $59. For tax purposes, what is the cost basis of the stock?
A. $50
B. $51
C. $54
D. $55
The best answer is D.
When a put is purchased on a stock on the same day that the stock is bought, the put is said to be “married” to the stock position. The only reason the option was purchased was to protect the customer against loss if the market for the stock fell. It was not purchased to speculate in the market. The IRS treats a “married” put as part of the cost basis of the stock. Notice that, therefore, the put premium cannot be deducted as a capital loss if the put expires worthless; instead, it has increased the stock’s cost basis and will reduce any potential capital gain, when, and if, the stock is sold. As one would expect, this is the tax treatment that is most beneficial to the IRS and least beneficial to the investor. The cost of the stock is $51 + $4 premium = $55 per share. When the stock is sold at $59, the customer reports a 4 point capital gain.
A customer buys 100 shares of XYZ stock at $51 and buys 1 XYZ Jan 50 Put @ $4 on the same day. The put expires and the stock is sold in the market for 59. For tax purposes, the put premium is:
A. a capital loss at expiration date
B. a capital loss at the date the stock is sold
C. added to the cost basis of the stock, reducing any capital gain when the stock is sold
D. subtracted from the strike price of the put, reducing any capital gain when the stock is sold
The best answer is C.
When a put is purchased on a stock on the same day that the stock is bought, the put is said to be “married” to the stock position. The only reason the option was purchased was to protect the customer against loss if the market for the stock fell. It was not purchased to speculate in the market. The IRS treats a “married” put as part of the cost basis of the stock. Notice that, therefore, the put premium cannot be deducted as a capital loss if the put expires worthless; instead, it has increased the stock’s cost basis and will reduce any potential capital gain, when, and if, the stock is sold. As one would expect, this is the tax treatment that is most beneficial to the IRS and least beneficial to the investor. The cost of the stock is $51 + $4 premium = $55 per share. When the stock is sold at $59, the customer reports a 4 point capital gain.
Which of the following can affect the holding period of a stock held short term?
A. Buy a call
B. Buy a put
C. Sell a call
D. Sell a put
The best answer is B.
If a customer buys stock and does not buy a put on the same day, then the put is not married to the stock. The worry of the IRS is that the customer might attempt to buy a put on stock that has appreciated in value to lock in a gain while the holding period is short-term, and then simply wait until the holding period is long term to sell the stock (either in the market or by exercising the put and be taxed at the lower 15% rate) without having been at risk. So if the put is purchased when the stock is held short-term, the IRS wipes out the holding period and it does not start counting again until the put expires (and it starts from day 1 at this point).
Note that if the put is married to the stock on the same day, the stock’s holding period counts normally; and if the stock was already held long term when the put was purchased, then the investor was not trying to stretch a short term capital gain to a long term capital gain without being at risk, and the holding period counts normally.
A customer sells short 100 shares of ABC stock at $63 per share. The stock falls to $47, at which point the customer writes 1 ABC Sept 45 Put at $2. The stock falls to $36 and the put is exercised. The customer’s cost basis upon exercise of the put is:
A. $43
B. $47
C. $69
D. $61
The best answer is A.
The customer sold the stock short at $63 per share (sale proceeds). Later, the customer sold a Sept 45 Put @ $2 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $45 per share. Since the customer received $2 in premiums when the put was sold, the net cost to the customer is $43 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer’s gain is: $63 sale proceeds - $43 cost basis = 20 point gain.
A customer sells short 100 shares of ABC stock at $50 per share. The stock falls to $40, at which point the customer writes 1 ABC Sept 40 Put at $4. The stock falls to $30 and the put is exercised. The customer’s cost basis upon exercise of the put is:
A. $36
B. $44
C. $46
D. $54
The best answer is A.
The customer sold the stock short at $50 per share (sale proceeds). Later, the customer sold a Sept 40 Put @ $4 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $40 per share. Since the customer received $4 in premiums when the put was sold, the net cost to the customer is $36 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer’s gain is: $50 sale proceeds - $36 cost basis = 14 point gain.
A customer sells short 100 shares of ABC stock at $74 per share. The stock falls to $66, at which point the customer writes 1 ABC Sept 65 Put at $3. The stock falls to $58 and the put is exercised. The customer’s cost basis upon exercise of the put is:
A. $62
B. $68
C. $71
D. $74
The best answer is A.
The customer sold the stock short at $74 per share (sale proceeds). Later, the customer sold a Sept 65 Put @ $3 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $65 per share. Since the customer received $3 in premiums when the put was sold, the net cost to the customer is $62 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer’s gain is: $74 sale proceeds - $62 cost basis = 12 point gain.
