How Options Are Taxed: Section 1256, Covered Calls, Wash Sales and Straddles

A familiar year-end surprise: an engineer writes covered calls on vested RSUs all year and books $60,000 of premium, then finds almost all of it taxed as short-term gain at 37% plus the 3.8% net investment income tax. A colleague who sold the same notional of calls on the S&P 500 index kept roughly $6,000 more of the same premium, because index options fall under Section 1256. Nothing about the trade was different except the contract. Options tax rules are mostly logical once you see the map, and they reward planning more than any other part of an investment account. If calls and puts are new to you, start with options basics for tech investors, then come back.

How are equity options taxed when you buy, sell, let expire or get assigned?

Options on individual stocks and on most ETFs are capital assets, so every result is a capital gain or loss, and the timing and character depend on which side you were on and how the position ended. Opening a position is never a taxable event on its own; the tax comes when it closes, expires or turns into stock. IRS Publication 550 and Section 1234 of the tax code set out the rules, and Chart 1 lays them out as a map.

If you bought the option, it behaves like any other asset you own. Sell it before expiry and the gain or loss is short-term if you held it one year or less, long-term if longer. Let it expire worthless and the IRS treats it as sold for zero on the expiration date, so you have a capital loss equal to the premium. Exercise it and nothing is taxed yet: for a call, the premium is added to the cost basis of the shares you buy; for a put, it reduces the proceeds of the shares you sell.

If you wrote (sold) the option, the premium is not income when you receive it. It is held in suspense until the position ends. Buy it back or let it expire and the result is always a short-term capital gain or loss, even if the option was open for two years. That is why most option income on single stocks is taxed at ordinary rates. If you are assigned, there is no separate option gain at all: the premium folds into the stock trade.

Two consequences follow. First, a written call or put on stock is the least tax-efficient way to earn income in a taxable account if you are in a high bracket, which is the core argument of our comparison of options income versus dividend investing. Second, long-dated bought options such as LEAPS can reach long-term treatment, but the option’s holding period does not carry over to stock you get by exercising it: the new shares’ clock starts the day after exercise.

What is Section 1256 and the 60/40 rule?

Section 1256 is the part of the tax code that gives certain contracts a fixed blend: 60% of any gain or loss is long-term and 40% is short-term, regardless of how long you held the position. It covers regulated futures contracts, certain foreign currency contracts and “nonequity options”, which include options on broad-based stock indexes such as the S&P 500 (SPX), the Nasdaq-100 (NDX) and the Russell 2000 (RUT), plus options on futures.

Two features come with the favorable rate:

• Mark-to-market at year end. Any Section 1256 position still open on the last business day of the year is treated as sold at fair market value, and the gain or loss is taxed that year. Next year your basis is adjusted so the same gain isn’t taxed twice. You cannot defer an SPX gain into January by holding the position over December 31.
• Loss carryback. Individuals can elect to carry a net Section 1256 loss back three years, but only against Section 1256 gains in those years. It is claimed on Form 6781 and is worth knowing about after a bad year of index hedging.

The arithmetic in Chart 2 is the whole case. At the top bracket, a short-term gain on an equity option is taxed at 37%, or 40.8% with the net investment income tax. The same gain on a Section 1256 contract is taxed at 0.6 × 20% + 0.4 × 37% = 26.8%, or 30.6% with the NIIT. On $100,000 of profit that is a difference of about $10,200 a year in federal tax alone, before state tax. For a trader whose options are open for days or weeks, the rule turns what would be fully short-term income into income that is mostly taxed at long-term rates.

The blend works both ways. A Section 1256 loss is also 60% long-term, which is less valuable than a fully short-term loss that could offset high-rate gains. And the mark-to-market rule means an open winning hedge creates a tax bill in December even though you have not closed it.

SPX vs SPY: why is the same exposure taxed differently?

SPX and SPY track the same index, but SPX options are broad-based index options and qualify for Section 1256, while SPY options are options on an ETF share and are generally taxed as equity options. The market exposure is almost identical; the contract design and the tax result are not.

For an investor in the top bracket, this makes the choice of instrument a source of after-tax return, what we call tax alpha. An index income overlay, an index hedge, or a short-dated trade such as SPX 0DTE will usually keep more after tax in SPX than in SPY. The same logic does not rescue single-stock options: options on Nvidia or Apple are equity options, and so are options on sector ETFs and on narrow indexes. If you want the 60/40 treatment, the contract must be a broad-based index option, a futures option, or a regulated futures contract.

SPY still has uses. Its smaller notional and share delivery suit a small account or a position you actually want to hold as shares. In an IRA or 401(k), the tax differences disappear entirely, so choose on liquidity and contract size.

How does assignment change your cost basis?

When an option is exercised or assigned, the premium stops being a separate item and becomes part of the stock trade, adjusting either your cost basis or your sale proceeds. The holding period of the stock, not the option, then decides whether the eventual gain is short- or long-term.

Here is an illustrative cycle through the wheel, the kind many readers run on a stock they like:

1. March: sell 10 puts on XYZ at the $100 strike for $4.00. Premium received: $4,000. No tax yet.
2. April: the stock closes at $95 and the puts are assigned. You buy 1,000 shares at $100, but your cost basis is $96 ($100 − $4). No option gain is reported. Holding period starts the next day.
3. May: sell 10 calls at the $105 strike for $3.00. Premium received: $3,000.
4. June: the stock rallies to $110 and the calls are assigned. Your proceeds are $108 a share ($105 + $3).
5. Result: a single short-term capital gain of ($108 − $96) × 1,000 = $12,000, reported on Form 8949 as a stock sale.

The same $7,000 of premium would have been two short-term option gains if the options had expired instead. The total is similar, but the timing is not: premium that folds into a stock position you hold into next year is not taxed until you sell the shares. Assignment of a call against low-basis RSU shares works the other way: it realizes the whole embedded gain, which is the most expensive way to end a covered call on concentrated stock.

Do wash sale rules apply to options?

Yes. Section 1091 treats contracts or options to acquire stock as stock for the wash sale rule, so if you sell shares at a loss and buy a call on the same company within 30 days before or after, the loss is disallowed and added to the basis of the replacement. Losses on the options themselves can also be wash sales if you reopen a substantially identical position inside the window.

The clear cases are in the left column of Chart 3. Buying the stock back, or buying a call on it, inside the 61-day window defers the loss. So does buying in your IRA, where the loss is not just deferred but effectively lost, because the basis adjustment does nothing inside a tax-deferred account. Purchases by your spouse count as well. Our guide to stock capital gains and wash sales covers the share-side rules and the common ETF swaps.

The middle column is where options get difficult. Publication 550 says whether securities are substantially identical depends on all the facts and circumstances, and the IRS has never published a strike-and-expiry test. Practitioners generally treat an option with a very different strike or expiry as less likely to be substantially identical than the same contract, but there is no safe harbor. The IRS has ruled that selling a deep in-the-money put inside the window can trigger a wash sale, because a put that is almost certain to be assigned works like a contract to buy the stock.

Two practical points. First, the rule only bites on losses; a gain is always taxed. Second, broker 1099-Bs track wash sales only within the same account and the same security identifier. Wash sales across accounts, across spouses or between stock and options are often your job to find.

What is a qualified covered call, and why does it matter?

A qualified covered call is a call written on stock you own that meets the tests in Section 1092(c)(4) and is therefore exempt from most of the straddle rules. Without that exception, stock plus a short call would be a straddle, and losses on one leg could be deferred while the other carries a gain.

To be qualified, the call must be:

• Exchange-traded, not a private over-the-counter contract.
• Written with more than 30 days to expiry.
• Not deep in the money: roughly, the strike cannot be below the first listed strike under the prior day’s closing price, with further limits for longer-dated calls and low-priced stocks.
• Not written by an options dealer in the ordinary course of business.

Two traps remain even for qualified calls. In-the-money qualified calls suspend the stock’s holding period while the call is open, so writing in-the-money calls on shares at month ten of their first year can delay long-term treatment. And a loss on an in-the-money qualified call can be treated as long-term if the stock’s gain would have been long-term. There is also a year-end rule: if you close one side at a loss in December and the other side carries a gain into January, the exception can be lost unless you keep the stock, unhedged, for 30 days after closing the call.

The practical fix is to write out-of-the-money calls with more than 30 days left on shares that are already long-term. That is also the sensible trade for income, as our guide to covered calls explains. Weekly calls written at the money on recently vested RSUs are the pattern most likely to fail the test.

How do the straddle rules defer losses on hedged positions?

A straddle, for tax purposes, is any pair of offsetting positions that substantially reduce your risk of loss, such as stock plus a bought put, stock plus a non-qualified short call, or a collar. Section 1092 then applies three rules that surprise hedged investors.

1. Loss deferral. A realized loss on one leg is deductible only to the extent it exceeds the unrecognized gain on the offsetting leg. Close a losing call while holding stock with a larger gain and the loss waits until the stock is sold.
2. Holding period. If the stock had been held for one year or less when the straddle began, its holding period is wiped out and restarts only when the straddle ends. Long-term status can be postponed indefinitely.
3. Carrying costs. Interest and other carrying charges on a straddle generally cannot be deducted currently; they are added to the basis of the stock.

Buying a put on stock you have held for one year or less also falls under the short-sale rules: Publication 550 treats it like a short sale, so the stock’s holding period stops and restarts later. The exception is a married put, bought on the same day as the stock and identified as a hedge of it. For executives who buy a protective put right after an RSU vest, the order and timing of the purchases matter.

None of this makes hedging a mistake. It means the hedge should be designed around lots that are already long-term, and that losses on the option leg should be expected to wait. When an RSU holder asks us to hedge a new vest, the first question is always how old the shares are.

When does a hedge become a constructive sale?

A hedge becomes a constructive sale when it removes substantially all of your risk of loss and opportunity for gain on an appreciated position. Section 1259 then treats you as having sold the stock on the day you entered the hedge, and the gain is taxed immediately even though you still own the shares.

The statute names specific transactions: a short sale of the same or substantially identical stock (“short against the box”), an offsetting swap, and a futures or forward contract to deliver the stock. Options are not listed, but the legislative history and practitioners treat a deep in-the-money put or a very tight collar as the kind of position that can qualify. Regulations defining the safe band for collars have never been issued, so there is no bright line.

There is a narrow exception for hedges that are closed quickly: a position closed within 30 days after year end, followed by 60 days of holding the stock unhedged, is disregarded. That is a timing tool, not a planning strategy.

For concentrated holders, the implication is to keep hedges wide. A zero-cost collar with a put at 90% and a call at 115% of the price leaves you with real gain and loss exposure; a 98/102 collar does not. Our collars and constructive sales guide works through strike choices with that line in mind.

How do you report option trades: Form 8949 or Form 6781?

Equity options go on Form 8949 and Section 1256 contracts go on Form 6781; both then flow to Schedule D. Your broker’s Form 1099-B does most of the sorting, but it does not know about positions you hold elsewhere.

Two reconciliation habits save the most time. First, check that assigned options are not reported both as an option gain and inside the stock trade; the 1099-B usually handles this, but transfers between brokers can break it. Second, if you receive a K-1 from a fund that trades futures or index options, its Section 1256 figures also belong on Form 6781.

What does a tax-aware options routine look like?

A tax-aware routine decides the instrument, the account and the strike before the trade, then runs a year-end check. This is the checklist we use when designing income and hedge programs for executives; it fits inside the broader plan in our tax-efficient investing guide.

1. Place by account. Keep high-turnover single-stock option writing in an IRA or 401(k) where the plan allows it; run index income and index hedges in taxable accounts using Section 1256 contracts.
2. Prefer broad-based index options for index exposure. Use SPX or XSP rather than SPY when the exposure is the same and the account is taxable.
3. Write covered calls on long-term lots. Use specific-lot identification, keep strikes out of the money with more than 30 days to expiry, and avoid writing against shares you would hate to have called away.
4. Check the age of stock before you hedge it. Puts and collars on shares held one year or less can reset the holding period.
5. Keep collars wide. Have your adviser review strikes for constructive-sale risk before you trade.
6. Run a wash sale sweep before harvesting. Look across every account, including your spouse’s and IRAs, for stock, calls and short puts on the same name within 30 days.
7. Estimate December’s mark-to-market. Open Section 1256 positions are taxed at year end, so size estimated payments accordingly.
8. Reconcile the 1099-B against your own records in February, before you file.

Frequently asked questions

Key takeaways

1. Written equity options always produce short-term results; bought options follow the one-year holding period; assignment folds the premium into the stock trade instead of creating a separate option gain.
2. Broad-based index options such as SPX are Section 1256 contracts: 60% long-term and 40% short-term regardless of holding period, marked to market at December 31, reported on Form 6781.
3. At the top bracket the gap is about 10 points: 40.8% on a short-term equity option gain versus 30.6% under Section 1256, both including the 3.8% NIIT.
4. Options count for the wash sale rule. A call bought within 30 days of a loss sale on the same stock can defer the loss, and your IRA and spouse’s accounts count too.
5. Covered calls are safe from the straddle rules only if they are qualified: listed, more than 30 days to expiry and not deep in the money. In-the-money qualified calls still suspend the stock’s holding period.
6. Protective puts and collars on appreciated stock bring in the straddle rules, and a band that is too tight can be a constructive sale under Section 1259.
7. Choose the instrument, the account and the strike with the tax result in mind, then confirm the plan with a tax adviser before year end.

Sources and method

1. IRS Publication 550, Investment Income and Expenses — options held and written, expiration, exercise and assignment, wash sales, straddles, constructive sales
2. 26 U.S. Code §1256, Section 1256 contracts marked to market — the 60/40 rule, year-end mark-to-market, definition of nonequity options
3. IRS, About Form 6781 — reporting Section 1256 contracts and straddles
4. IRS, About Form 8949 — reporting sales of capital assets, including equity options
5. 26 U.S. Code §1234, Options to buy or sell — character of option gains and losses; written options as short-term
6. 26 U.S. Code §1091, Wash sales — the 61-day window and options treated as stock
7. 26 U.S. Code §1092, Straddles — loss deferral, holding periods and the qualified covered call exception in §1092(c)(4)
8. 26 U.S. Code §1259, Constructive sales — when a hedge on appreciated stock is treated as a sale
9. IRS Topic 409, Capital gains and losses — short-term and long-term rates
10. IRS, Net Investment Income Tax — the additional 3.8% and its income thresholds

This article summarizes general federal income tax rules for individual US investors trading listed options in taxable accounts, as of 2026. It is not tax advice: state tax, trader-status elections, mixed straddle elections and your own facts can change the answer, so confirm with a tax adviser before acting. Rates in Chart 2 are published top federal rates combined arithmetically; option prices, premiums and positions in the worked examples are illustrative, not quotes or recommendations.