Publication 550
Investment Income and Expenses

(Including Capital Gains and Losses)

For use in preparing 2002 Returns

Options

Options are generally subject to the rules described in this section. If the option is part of a straddle, the loss deferral rules covered later under Straddles may also apply. For special rules that apply to nonequity options and dealer equity options, see Section 1256 Contracts Marked to Market, earlier.

Gain or loss from the sale or trade of an option to buy or sell property that is a capital asset in your hands, or would be if you acquired it, is capital gain or loss. If the property is not, or would not be, a capital asset, the gain or loss is ordinary gain or loss.

Example 1.   You purchased an option to buy 100 shares of XYZ Company stock. The stock increases in value and you sell the option for more than you paid for it. Your gain is capital gain because the stock underlying the option would have been a capital asset in your hands.

Example 2.   The facts are the same as in Example 1, except that the stock decreases in value and you sell the option for less than you paid for it. Your loss is a capital loss.

Option not exercised.   If you have a loss because you did not exercise an option to buy or sell, you are considered to have sold or traded the option on the date that it expired.

Writer of option.   If you write (grant) an option, how you report your gain or loss depends on whether it was exercised.

If you are not in the business of writing options and an option you write on stocks, securities, commodities, or commodity futures is not exercised, the amount you receive is a short-term capital gain.

If an option requiring you to buy or sell property is exercised, see Writers of calls and puts, later.

Section 1256 contract options.   Gain or loss is recognized on the exercise of an option on a section 1256 contract. Section 1256 contracts are defined under Section 1256 Contracts Marked to Market, earlier.

Cash settlement option.   A cash settlement option is treated as an option to buy or sell property. A cash settlement option is any option that on exercise is settled in, or could be settled in, cash or property other than the underlying property.

How to report.   Gain or loss from the closing or expiration of an option that is not a section 1256 contract, but that is a capital asset in your hands, is reported on Schedule D (Form 1040).

If an option you purchased expired, enter the expiration date in column (c) and write EXPIRED in column (d).

If an option that you wrote expired, enter the expiration date in column (b) and write EXPIRED in column (e).

Calls and Puts

Calls and puts are options on securities and are covered by the rules just discussed for options. The following are specific applications of these rules to holders and writers of options that are bought, sold, or closed out in transactions on a national securities exchange, such as the Chicago Board Options Exchange. (But see Section 1256 Contracts Marked to Market, earlier, for special rules that may apply to nonequity options and dealer equity options.) These rules are also presented in Table 4-1.

Calls and puts are issued by writers (grantors) to holders for cash premiums. They are ended by exercise, closing transaction, or lapse.

A call option is the right to buy from the writer of the option, at any time before a specified future date, a stated number of shares of stock at a specified price. Conversely, a put option is the right to sell to the writer, at any time before a specified future date, a stated number of shares at a specified price.

Holders of calls and puts.   If you buy a call or a put, you may not deduct its cost. It is a capital expenditure.

If you sell the call or the put before you exercise it, the difference between its cost and the amount you receive for it is either a long-term or short-term capital gain or loss, depending on how long you held it.

If the option expires, its cost is either a long-term or short-term capital loss, depending on your holding period, which ends on the expiration date.

If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock.

Put option as short sale.   Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. See Short Sales, earlier. If you have held the underlying stock for 1 year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration. Your holding period for the underlying stock begins on the earliest of:

1. The date you dispose of the stock,
2. The date you exercise the put,
3. The date you sell the put, or
4. The date the put expires.

Writers of calls and puts.   If you write (grant) a call or a put, do not include the amount you receive for writing it in your income at the time of receipt. Carry it in a deferred account until:

1. Your obligation expires,
2. You sell, in the case of a call, or buy, in the case of a put, the underlying stock when the option is exercised, or
3. You engage in a closing transaction.

If your obligation expires, the amount you received for writing the call or put is short-term capital gain.

If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss. The gain or loss is long term or short term depending on your holding period of the stock.

If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put. Your holding period for the stock begins on the date you buy it, not on the date you wrote the put.

If you enter into a closing transaction by paying an amount equal to the value of the call or put at the time of the payment, the difference between the amount you pay and the amount you receive for the call or put is a short-term capital gain or loss.

Examples of non-dealer transactions.  

1. Expiration. Ten JJJ call options were issued on April 8, 2002, for $4,000. These equity options expired in December 2002, without being exercised. If you were a holder (buyer) of the options, you would recognize a short-term capital loss of $4,000. If you were a writer of the options, you would recognize a short-term capital gain of $4,000.
2. Closing transaction. The facts are the same as in (1), except that on May 10, 2002, the options were sold for $6,000. If you were the holder of the options who sold them, you would recognize a short-term capital gain of $2,000. If you were the writer of the options and you bought them back, you would recognize a short-term capital loss of $2,000.
3. Exercise. The facts are the same as in (1), except that the options were exercised on May 27, 2002. The buyer adds the cost of the options to the basis of the stock bought through the exercise of the options. The writer adds the amount received from writing the options to the amount realized from selling the stock.
4. Section 1256 contracts. The facts are the same as in (1), except the options were nonequity options, subject to the rules for section 1256 contracts. If you were a buyer of the options, you would recognize a short-term capital loss of $1,600, and a long-term capital loss of $2,400. If you were a writer of the options, you would recognize a short-term capital gain of $1,600, and a long-term capital gain of $2,400. See Section 1256 Contracts Marked to Market, earlier, for more information.

Table 4-1. Puts and Calls

Straddles

This section discusses the loss deferral rules that apply to the sale or other disposition of positions in a straddle. These rules do not apply to the straddles described under Exceptions, later.

A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period.

Personal property.   This is any property of a type that is actively traded. It includes stock options and contracts to buy stock, but generally does not include stock.

Straddle rules for stock.   Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations.

1. The stock is part of a straddle in which at least one of the offsetting positions is:
   1. An option to buy or sell the stock or substantially identical stock or securities,
   2. A securities futures contract on the stock or substantially identical stock or securities, or
   3. A position on substantially similar or related property (other than stock).
2. The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.

Position.   A position is an interest in personal property. A position can be a forward or futures contract, or an option.

An interest in a loan that is denominated in a foreign currency is treated as a position in that currency. For the straddle rules, foreign currency for which there is an active interbank market is considered to be actively-traded personal property. See also Foreign currency contract under Section 1256 Contracts Marked to Market, earlier.

Offsetting position.   This is a position that substantially reduces any risk of loss you may have from holding another position. However, if a position is part of a straddle that is not an identified straddle (described later), do not treat it as offsetting to a position that is part of an identified straddle.

Presumed offsetting positions.   Two or more positions will be presumed to be offsetting if:

1. The positions are established in the same personal property (or in a contract for this property), and the value of one or more positions varies inversely with the value of one or more of the other positions,
2. The positions are in the same personal property, even if this property is in a substantially changed form, and the positions' values vary inversely as described in the first condition,
3. The positions are in debt instruments with a similar maturity, and the positions' values vary inversely as described in the first condition,
4. The positions are sold or marketed as offsetting positions, whether or not the positions are called a straddle, spread, butterfly, or any similar name, or
5. The aggregate margin requirement for the positions is lower than the sum of the margin requirements for each position if held separately.

Related persons.   To determine if two or more positions are offsetting, you will be treated as holding any position that your spouse holds during the same period. If you take into account part or all of the gain or loss for a position held by a flowthrough entity, such as a partnership or trust, you are also considered to hold that position.

Loss Deferral Rules

Generally, you can deduct a loss on the disposition of one or more positions only to the extent that the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.

Unrecognized gain.   This is:

1. The amount of gain you would have had on an open position if you had sold it on the last business day of the tax year at its fair market value, and
2. The amount of gain realized on a position if, as of the end of the tax year, gain has been realized, but not recognized.

Example.   On July 1, 2002, you entered into a straddle. On December 16, 2002, you closed one position of the straddle at a loss of $15,000. On December 31, 2002, the end of your tax year, you have an unrecognized gain of $12,750 in the offsetting open position. On your 2002 return, your deductible loss on the position you closed is limited to $2,250 ($15,000 - $12,750). You must carry forward to 2003 the unused loss of $12,750.

Exceptions.   The loss deferral rules do not apply to:

1. A straddle that is an identified straddle at the end of the tax year,
2. Certain straddles consisting of qualified covered call options and the stock to be purchased under the options,
3. Hedging transactions, described earlier under Section 1256 Contracts Marked to Market, and
4. Straddles consisting entirely of section 1256 contracts, as described earlier under Section 1256 Contracts Marked to Market (but see Identified straddle, next).

Identified straddle.   Losses from positions in an identified straddle are deferred until you dispose of all the positions in the straddle.

Any straddle (other than a straddle described in (2) or (3) above) is an identified straddle if all of the following conditions exist.

1. You clearly identified the straddle on your records before the close of the day on which you acquired it.
2. All of the original positions that you identify were acquired on the same day.
3. All of the positions included in item (2) were disposed of on the same day during the tax year, or none of the positions were disposed of by the end of the tax year.
4. The straddle is not part of a larger straddle.

Qualified covered call options and optioned stock.   A straddle is not subject to the loss deferral rules for straddles if both of the following are true.

1. All of the offsetting positions consist of one or more qualified covered call options and the stock to be purchased from you under the options.
2. The straddle is not part of a larger straddle.

But see Special year-end rule, later, for an exception.

A qualified covered call option is any option you grant to purchase stock you hold (or stock you acquire in connection with granting the option), but only if all of the following are true.

1. The option is traded on a national securities exchange or other market approved by the Secretary of the Treasury.
2. The option is granted more than 30 days before its expiration date.
3. The option is not a deep-in-the-money option.
4. You are not an options dealer who granted the option in connection with your activity of dealing in options.
5. Gain or loss on the option is capital gain or loss.

A deep-in-the-money option is an option with a strike price lower than the lowest qualified benchmark (LQB). The strike price is the price at which the option is to be exercised. The LQB is the highest available strike price that is less than the applicable stock price. However, the LQB for an option with a term of more than 90 days and a strike price of more than $50 is the second highest available strike price that is less than the applicable stock price. Strike prices are listed in the financial section of many newspapers.

The availability of strike prices for equity options with flexible terms does not affect the determination of the LQB for an option that is not an equity option with flexible terms.

The applicable stock price for any stock for which an option has been granted is:

1. The closing price of the stock on the most recent day on which that stock was traded before the date on which the option was granted, or
2. The opening price of the stock on the day on which the option was granted, but only if that price is greater than 110% of the price determined in (1).

If the applicable stock price is $25 or less, the LQB will be treated as not less than 85% of the applicable stock price. If the applicable stock price is $150 or less, the LQB will be treated as not less than an amount that is $10 below the applicable stock price.

Example.   On May 13, 2002, you held XYZ stock and you wrote an XYZ/September call option with a strike price of $120. The closing price of one share of XYZ stock on May 12, 2002, was $130.25. The strike prices of all XYZ/September call options offered on May 13, 2002, were as follows: $110, $115, $120, $125, $130, and $135. Because the option has a term of more than 90 days, the LQB is $125, the second highest strike price that is less than $130.25, the applicable stock price. The call option is a deep-in-the-money option because its strike price is lower than the LQB. Therefore, the option is not a qualified covered call option, and the loss deferral rules apply if you closed out the option or the stock at a loss during the year.

Capital loss on qualified covered call options.   If you hold stock and you write a qualified covered call option on that stock with a strike price less than the applicable stock price, treat any loss from the option as long-term capital loss if, at the time the loss was realized, gain on the sale or exchange of the stock would be treated as long-term capital gain. The holding period of the stock does not include any period during which you are the writer of the option.

Special year-end rule.   The loss deferral rules for straddles apply if all of the following are true.

1. The qualified covered call options are closed or the stock is disposed of at a loss during any tax year.
2. Gain on disposition of the stock or gain on the options is includible in gross income in a later tax year.
3. The stock or options were held less than 30 days after the closing of the options or the disposition of the stock.

How To Report Gains
and Losses (Form 6781)

Report each position (whether or not it is part of a straddle) on which you have unrecognized gain at the end of the tax year and the amount of this unrecognized gain in Part III of Form 6781. Use Part II of Form 6781 to figure your gains and losses on straddles before entering these amounts on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return.

Coordination of Loss Deferral Rules and Wash Sale Rules

Rules similar to the wash sale rules apply to any disposition of a position or positions of a straddle. First apply Rule 1, explained next, then apply Rule 2. However, Rule 1 applies only if stocks or securities make up a position that is part of the straddle. If a position in the straddle does not include stock or securities, use Rule 2.

Rule 1.   You cannot deduct a loss on the disposition of shares of stock or securities that make up the positions of a straddle if, within a period beginning 30 days before the date of that disposition and ending 30 days after that date, you acquired substantially identical stock or securities. Instead, the loss will be carried over to the following tax year, subject to any further application of Rule 1 in that year. This rule will also apply if you entered into a contract or option to acquire the stock or securities within the time period described above. See Loss carryover, later, for more information about how to treat the loss in the following tax year.

Dealers.   If you are a dealer in stock or securities, this loss treatment will not apply to any losses you sustained in the ordinary course of your business.

Example.   You are not a dealer in stock or securities. On December 2, 2002, you bought stock in XX Corporation (XX stock) and an offsetting put option. On December 13, 2002, there was $20 of unrealized gain in the put option and you sold the XX stock at a $20 loss. By December 16, the value of the put option had declined, eliminating all unrealized gain in the position. On December 16, you bought a second XX stock position that is substantially identical to the XX stock you sold on December 13. At the end of the year there is no unrecognized gain in the put option or in the XX stock. Under these circumstances, the $20 loss will be disallowed for 2002 under Rule 1 because, within a period beginning 30 days before December 13, and ending 30 days after that date, you bought stock substantially identical to the XX stock you sold.

Rule 2.   You cannot deduct a loss on the disposition of less than all of the positions of a straddle (your loss position) to the extent that any unrecognized gain at the close of the tax year in one or more of the following positions is more than the amount of any loss disallowed under Rule 1:

1. Successor positions,
2. Offsetting positions to the loss position, or
3. Offsetting positions to any successor position.

Successor position.   A successor position is a position that is or was at any time offsetting to a second position, if both of the following conditions are met.

1. The second position was offsetting to the loss position that was sold.
2. The successor position is entered into during a period beginning 30 days before, and ending 30 days after, the sale of the loss position.

Example 1.   On November 1, 2002, you entered into offsetting long and short positions in non-section 1256 contracts. On November 12, 2002, you disposed of the long position at a $10 loss. On November 14, you entered into a new long position (successor position) that is offsetting to the retained short position, but that is not substantially identical to the long position disposed of on November 12. You held both positions through year end, at which time there was $10 of unrecognized gain in the successor long position and no unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for 2002 because there is $10 of unrecognized gain in the successor long position.

Example 2.   The facts are the same as in Example 1, except that at year end you have $4 of unrecognized gain in the successor long position and $6 of unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for 2002 because there is a total of $10 of unrecognized gain in the successor long position and offsetting short position.

Example 3.   The facts are the same as in Example 1, except that at year end you have $8 of unrecognized gain in the successor long position and $8 of unrecognized loss in the offsetting short position. Under these circumstances, $8 of the total $10 realized loss will be disallowed for 2002 because there is $8 of unrecognized gain in the successor long position.

Loss carryover.   If you have a disallowed loss that resulted from applying Rule 1 and Rule 2, you must carry it over to the next tax year and apply Rule 1 and Rule 2 to that carryover loss. For example, a loss disallowed in 2001 under Rule 1 will not be allowed in 2002, unless the substantially identical stock or securities (which caused the loss to be disallowed in 2001) were disposed of during 2002. In addition, the carryover loss will not be allowed in 2002 if Rule 1 or Rule 2 disallows it.

Example.   The facts are the same as in the example under Rule 1 above. On December 31, 2003, you sell the second XX stock at a $20 loss and there is $40 of unrecognized gain in the put option. Under these circumstances, you cannot deduct in 2003 either the $20 loss disallowed in 2002 or the $20 loss you incurred for the December 31, 2003, sale of XX stock. Rule 1 does not apply because the substantially identical XX stock was sold during the year and no substantially identical stock or securities were bought within the 61-day period. However, Rule 2 does apply because there is $40 of unrecognized gain in the put option, an offsetting position to the loss positions.

Capital loss carryover.   If the sale of a loss position would have resulted in a capital loss, you treat the carryover loss as a capital loss on the date it is allowed, even if you would treat the gain or loss on any successor positions as ordinary income or loss. Likewise, if the sale of a loss position (in the case of section 1256 contracts) would have resulted in a 60% long-term capital loss and a 40% short-term capital loss, you treat the carryover loss under the 60/40 rule, even if you would treat any gain or loss on any successor positions as 100% long-term or short-term capital gain or loss.

Exceptions.   The rules for coordinating straddle losses and wash sales do not apply to the following loss situations.

1. Loss on the sale of one or more positions in a hedging transaction. (Hedging transactions are described under Section 1256 Contracts Marked to Market, earlier.)
2. Loss on the sale of a loss position in a mixed straddle account. (See the discussion later on the mixed straddle account election.)
3. Loss on the sale of a position that is part of a straddle consisting only of section 1256 contracts.

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