Options trading losses tax deductible
A wash sale is a sale of a security stocks , bonds , options at a loss and repurchase of the same or substantially identical security shortly before or after.
The security is then repurchased in the hope that it will recover its previous value, which would only become taxable in some future tax year. A wash sale can take place at any time during the year. In the UK, a similar practice which specifically takes place at the end of a calendar year is known as bed and breakfasting. In a bed-and-breakfasting transaction, a position is sold on the last trading day of the year typically late in the trading session to establish a tax loss.
The same position is then repurchased early on the first session of the new trading year, to restore the position albeit at a lower cost basis. The term, therefore, derives its name from the late sale and early morning repurchase.
In some tax codes, such as the USA and the UK, tax rules have been introduced to disallow the practice e. The disallowed loss is added to the basis of the newly acquired security.
Under Section , a wash sale occurs when a taxpayer sells or trades stock or securities at a loss, and within 30 days before or after the sale: The "substantially identical stock" acquired in any of these ways is called the "replacement stock" for that original position.
After a sale is identified as a wash sale and if the replacement stock is bought within 30 days before or after the sale then the wash sale loss is added to the basis of the replacement stock.
The basis adjustment is important as it preserves the benefit of the disallowed loss; the holder receives that benefit on a future sale of the replacement stock. The identification of a wash sale and adjusting the basis of the replacement stock is an iterative process. Gains or losses realized by a writer seller of naked uncovered options are normally treated as income.
However, according to ITR Transactions in Securities Archived , paragraph 25 c , CRA will allow these to be treated as capital gains, provided this practice is followed consistently from year to year.
For taxpayers who record gains and losses from options as income , the income from options sold written is reported in the tax year in which the options expire, or are exercised or bought back. When call options are purchased and subsequently exercised, the cost of the options is added to the cost base of the purchased shares.
If the call options are not exercised, the cost is deducted in the tax year in which the options expire. If the call options are closed out by selling them, the proceeds are included in income, and the original cost is written off, in the tax year in which the options are closed out. When put options are purchased, the cost is written off in the year in which the options expire, are exercised, or are closed out by selling them.
For taxpayers who record gains and losses from options as capital gains or losses , the timing is a little trickier for options which have been sold. The following table shows the timing of the recording of gains and losses on options that have been sold or purchased. Event Timing of proceeds reported for tax purposes Tax treatment when options are sold: To revise the capital gains from the previous year, a T1Adj would have to be filed.
See our article on changing your tax return after it has been filed. Of course, if the prior year tax return has not been filed when the options are exercised, the prior year return can be done omitting the gain, eliminating the need for a later revision.
The cost base of the option is the amount of expenditure incurred by the taxpayer in respect of the grant of the option [ Section ZZC 6 of the ITAA. That is, if the option requires the option seller to sell shares, the option premium forms part of the consideration received by the option seller in respect of the shares sold. Alternatively, if the option requires the option seller to acquire shares, the option premium will be deducted from the purchase consideration given by the option seller in respect of the acquisition of the shares.
Thus, in effect, the consideration is the net cost. This structure will give rise to the need to request an amended assessment where an option is granted in one year of income and is subsequently exercised in a later year of income. This is an extremely onerous result. What the CGT provisions effectively require, if the option is exercised, is the inclusion of the premium as a capital gain twice. The following example demonstrates the CGT consequences of a taxpayer who writes a call option.
The indexed cost base of the shares to Mr X at the time the option is exercised [ The timing of the disposal of the shares, for CGT purposes, is not entirely free from doubt. The better view appears to be that the disposal of the shares takes place when the option is exercised Division 13 of Part IIIA of the Income Tax Assessment Act treats the option, and the property the subject of the option, as distinct assets.
A number of difficult tax issues arise for a taxpayer who writes an option to hedge a transaction on capital account and that position is subsequently closed out. As stated above, the grant of an option will be a deemed disposal of the option at the time the option is granted.
Basically, the premium received would be a capital gain arising at the time of writing the option. However, there are no obvious provisions in the Income Tax Assessment Act which reverse that gain when the option is closed out as would be the case if the option was exercised by the grantee of the option.
A subsequent capital loss might arise when the position is closed out. However, the ATO may argue that a subsequent capital loss may not arise to offset against the earlier capital gain. The ATO could argue that the purchased option which closes out the earlier written option has been disposed of for no consideration [To sustain the argument that the option has been disposed of for no consideration, the reference to "consideration" in Section ZD 2 a of the ITAA would have been restricted to money or other property that is, it would have to exclude contractual consideration.
If Section ZD 2 a excludes contractual consideration, the purchased option to close out the overall option position would have arguably been disposed of for no consideration and, therefore, the market value of the purchased option would be deemed to have been received.
That being the case, no loss would arise for tax purposes to offset the earlier capital gain. This is clearly an absurd result, where taxpayers would be subject to CGT on their receipts from opening a written option position, but obtain no CGT relief on the cost of closing out that position. Income or losses relating to option transactions are not assessable or deductible until the income or loss is realised.
From the above, the following rules of thumb emerge. Traders receive a deduction when the option premium is due and payable subject to the 13 month rule and the trading stock rules if these rules apply - unless the net profit approach is adopted where they will be assessed on income when the option contract is closed out. If the option is exercised traders will be assessed on gains and losses ultimately reflected in the price of the shares. Speculators will be assessed on net profits or losses when the speculator closes out his or her position or the option lapses.
However if the speculator is an individual engaged in an isolated transaction, any gain will not be assessed until the cash is received. Traders and speculators will both be assessed on the premium when it is due and receivable, unless the option was sold as part of an isolated transaction by an individual, in which case the premium would be assessable when received.
If the hedge is on revenue account, hedgers will be entitled to a deduction in the same way as a trader. If the hedge is on capital account and the option lapses hedgers will be entitled to a capital loss at the time of expiry. If the hedge is on capital account and the option is exercised, the premium paid by the hedger would form part of the cost base in respect of the underlying shares or a reduction in the disposal proceeds from the sale of the shares.
If the hedge is on capital account and the option is closed out, hedgers will be assessed on the proceeds in excess of the premium. If the hedge is on revenue account, hedgers will be assessed in the same way as a trader.
If the hedge is on capital account and the option lapses, hedgers will be assessed on the capital gain premium paid when the option was granted. If the hedge is on capital account and the option is exercised, the premium received would reduce the consideration for the acquisition of the shares or, alternatively, increase the disposal proceeds from the sale of the shares.
If the hedge is on capital account and the option is closed out, hedgers will be assessed on the proceeds in excess of the premium received [This treatment is more an economic result than a strict interpretation of the CGT sections of the ITAA. The CGT sections of the Income Tax Assessment Act do not readily accommodate a written open position which is subsequently closed out by a buy position. See, for example, the footnote immediately above.
In the Budget, the Federal Government announced that it had decided to introduce a comprehensive legislative regime for the taxation of financial arrangements on an accruals basis. The Issues Paper proposes to codify the taxation treatment of a range of financial arrangements, including debt, derivatives, foreign currency and traded equity instruments. Outlined below is a general overview of how the proposed rules would apply to options.
The proposed general rule is that all income and expenses and gains and losses on financial arrangements be taxed on revenue account. Market value tax accounting will apply to derivatives held for trading purposes whereas hedge tax accounting rules will apply to derivatives held for hedging purposes.
Options are included in the definition of derivatives for the purposes of the Issues Paper. The Issues Paper states that where a derivative does not meet the definition of a hedge for the purposes of the hedge tax accounting rules see below it will be assumed that the derivative was acquired for trading purposes and will be subject to the market value tax accounting rules. Market value tax accounting is defined in the Issues Paper as a method of tax accounting that takes into account changes in the value of a financial arrangement over the year of income.
Under market value tax accounting the gain or loss from an asset or liability for a particular period is the increase or decrease in market value between the beginning and the end of the period, adjusted for amounts paid or received. The Issue Paper states that where the market for a financial arrangement such as an option is well established and liquid, market value tax accounting would be on a mark to market basis.
Under the mark to market method the value of the financial arrangement would be calculated using the last publicly quoted market price for the year of income. Taxpayers would be able to select one of the bid, offer or an average between those two prices in calculating the value of a financial arrangement provided that the market price chosen is appropriate to the transaction, is accepted by and widely used in the financial industry and is used consistently by the taxpayer.
In relation to hedge tax accounting, the Issues Paper states that the asset the derivative seeks to hedge provides the taxation reference point for the derivative. To qualify for hedge treatment it is proposed that in broad terms the hedge transaction must be entered into to reduce, and must be inversely correlated with, the risk arising out of an identified transactional position. Under the proposed hedge tax accounting rules the risk that is sought to be managed would need to be a risk that the taxpayer reasonably considers it has an exposure to.
The risk may be evaluated at the entity level or lower and may be in respect of a portfolio or in respect of a single transaction. If the risk is evaluated on a portfolio basis all the items of that portfolio must be taxed homogeneously. The action taken by the taxpayer: However, hedge treatment would not be disallowed if the effect of reducing the identified risk was to assume risk at another level, say at an enterprise level.
It will for the taxpayer to determine what the risk is and how it is to be evaluated. The Issues Paper states that a number of record keeping requirements will be imposed on taxpayers seeking to apply the hedge tax accounting rules. General Rules of Hedge Tax Accounting The tax accounting method used in relation to the underlying position should also be adopted in respect of the hedge. The hedge gain or loss should be brought to account in the same period as the corresponding gain or loss on the underlying position.
If a loss or gain arises as a result of the hedge being entered into, the Issues Paper states that this loss or gain should be amortised over the period in which any gains or losses on the underlying assets are taxed.
If the gain from the underlying transaction is accrued, the hedge gain or loss would need to be amortised consistently with the accrual method used in respect of the underlying transaction. Where a hedge is closed out early, the proposed hedge tax accounting rules will require that any gain or loss made while the hedge was effective be taxed in the same manner and year of income as any gain or loss made on the underlying transaction. Where the underlying transaction is closed out early, hedge tax accounting would apply to any gain or loss made on the hedge while it was effective that is, until the underlying transaction was closed out.
Once the hedge is no longer effective the hedge will be deemed to have been closed out for its market value. The taxpayer is then deemed to have acquired a new financial arrangement and to have given as consideration for its acquisition an amount equal to its market value.
Where an underlying transaction is not a financial arrangement and is taxed on a realisation basis such as shares held for investment purposes , the general hedge tax accounting rules will require that any gain or loss on a hedge not be taxed until the corresponding loss or gain on the underlying position is realised. However, the Issues Paper recognises that an underlying transaction may not have a fixed realisation point. It therefore proposes that, in general, any hedge gain or loss be taxed on the maturity of the hedge rather than on the maturity of the underlying transaction.
If the hedge is closed out early any gain or loss would be taxed on the original maturity date of the hedge. If the underlying transaction is closed out early a notional gain or loss would arise on the hedge at the time the underlying transaction is closed out. Any further gain or loss made on the derivative after it ceases to be an effective hedge would be taxed in accordance with the market value tax accounting rules discussed above. The Issue Paper states that, in general, gains and losses arising in respect of hedges of underlying capital transactions would not be on capital account.
An exception to this rule would arise where the gain or loss on a hedge of a capital non financial transaction such as shares held on capital account would be taxed in the same year of income as the offsetting loss or gain. To the extent that a hedge gain is brought to account in the same year of income as that of an offsetting capital loss on the underlying position, it is proposed to treat the hedge gain as a capital gain.
A general hedge for the purposes of the Issues Paper is the hedging of the aggregate risk of a number of transactions or portfolios. The Issue Paper recognises that a general hedge often hedges a net risk, being the risk exposure remaining after the effect of natural hedges have been taken into account.
The hedge tax accounting rules for general hedges requires that the underlying risk exposure be separated into hedges of financial arrangements and hedges of non financial arrangements. Where the underlying financial arrangement risk exposure offsets the underlying non financial arrangement risk exposure this would be accepted as a natural hedge.
The proposed general hedge rules would then apply to any excess exposure after this offset. Where a general hedge is in respect of an underlying transaction consisting solely of non financial arrangements, hedge gains and losses would be taxed on the original maturity of the hedge. Where a general hedge is in respect of an underlying portfolio consisting solely of financial arrangements the hedge gains or losses would be taxed on the basis that reasonably approximates the general hedge tax accounting rules for financial arrangements.
The rules relating to the early close out of the underlying position only apply to general hedges where it is clear that the underlying portfolio has been disposed of in part or full.
The Issues Paper recognises that a taxpayer may in a particular accounting period report a gain or loss from what are in effect internal dealings. For the purposes of the Issues Paper, internal deals are dealings between the business units of a legal entity where the dealings are financial arrangements entered into for hedging purposes by one of the business units. The Issues Paper lists a number of factors that will be taken into account in determining whether or not a transaction is an internal hedge, including whether: The Issues Paper further states that internal transactions between business units that are subject to different rates of tax would not qualify as internal hedges for the purposes of the hedge tax accounting rules.
The measures proposed in Budget Press Release No 47 are designed, inter alia, to prevent short-term franking credit trading where franking credits and the intercorporate dividend rebate would be received by taxpayers who are not carrying the economic risks and benefits of share ownership. Under the measures proposed in Budget Press Release No 47, taxpayers who engage in franking credit trading would be denied access to franking credits and to the intercorporate dividend rebate in respect of dividends received.