Option Investor
Educational Article

Tax Accounting Made Simple

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By Jim Crimmons

Our new column having to do with the taxation of your trading account begins today, and will be featured twice a month. Since taxes are the largest expense an active successful trader will have it is appropriate that we feature this information for you to use.

Our tax column is written by TradersAccounting.com a tax and accounting firm which specializes in preparing tax returns for active traders. In addition they have a department within the company that does tax planning for all levels of traders. To reach them you should go to their web site at http://www.TradersAccounting.com., or email your tax questions to Contact Support for a free answer. They feature some free items on the web site. As with any general information you should not rely upon the information given here to fit your own tax situation. Always consult with a professional on any tax matter.

Since this is the first of ongoing columns we will start with the basics today. The start of basics is insuring that we talk in the future about options in the same manner. Therefore, while it may seem kindergartenish, we must start with a few definitions, because the tax code is based around these definitions. To be a successful trader you have been taught that the most important item is to have a trading plan. Part of your trading plan must be a plan that takes into consideration your largest expense, that of the taxes you pay. We will give you the information over the next few weeks that will help you to add tax strategies to your trading plan.

What is an Option?

For the purpose of the IRS, an option is a contract in which an individual investor, a trader, or a business doing trading within an entity, in return for consideration of some type, grants for a specified time to a purchaser of the option, the privilege of purchasing from or selling to certain specified property at a fixed price to the grantor. Under this contract, only the grantor (or writer) is obligated to perform the purchaser may choose to exercise the option, or may allow it to lapse. The property specified in the option is referred to as the "underlying property, or security".

What is the difference between an option and a cash settlement option?

In a cash settlement option, the settlement may be settled in cash or property, other than the underlying property. For example, an option on a stock index, which contemplates that cash rather than stock is transferred if the option holder elects to exercise the option, is a cash settlement option.

How are options classified for purposes of the Federal Income Tax?

Options are categorized as listed or unlisted options, also as equity or non-equity option.

LISTED OPTIONS-A listed option is an option that is traded on or subject to the rules of (1) A national securities exchange registered with the SEC; (2) a domestic board of trade which has been designated as a contract market by the Commodities Future Trading Commission (CFTC); or another exchange, board of trade, or market designated by the Secretary of the Treasury. A listed option covers 100 shares of a particular stock, specifies a fixed (strike) price per share for exercise, and has a fixed expiration date. The premiums paid by the purchaser of the option and the transaction costs are not fixed. NON-LISTED OPTIONS-All other options are considered unlisted, and are traded over the counter. They generally have no fixed elements such as the number of shares covered, strike price premium and expiration and each of these elements are negotiated between the writer and purchaser. Here is no intermediary organization; therefore the writer and purchaser have the contract between themselves until it is settled. EQUITY OPTIONS-An option is an equity option, whether it is listed or not, if it is an option to buy or sell a stock, or its value is determined by reference to a particular stock. NON-EQUITY OPTION-If the CFTC has designated a contract market for trading such options or if the Treasury has determined that the requirements for the CFTC designation have been met, then the option is a non-equity option.

Each of the above definitions will become important to our study as each column is written.

Can Wash Sales be present when I am trading options? What is an Wash Sale?

A wash sale is a sale in which the seller, within a 61-day window, which begins 30 days before and ends 30 days after the date of a sale of a stock or security for a loss, replaces the stock or security by acquiring (purchase or exchange), or enters into a contract or option to acquire substantially identical stock or securities.

It therefore would seem that if you either sold an option or a stock at a loss, and then replaced it with a similar or identical security or option you would be saddled with the wash sale rule.

As can be seen from the above table in transaction two we would have a cumulative $10 per share loss because we sold stock (or options) at $90 while we had purchased them at $100. The next day our stock hit our technical entry point where we believed we should buy in again. At this point, because the transactions, first a loss, then the re-purchase of the identical stock, was within the window of time described above, (a 61 day window) we no longer have a loss to report, we have only adjusted our basis. You can see that if we continue to trade the same stock or options throughout the year that we possibly would never realize a loss, but would be adding to our basis on each purchase.

CAUTION: The wash sale rule can greatly influence the profit or loss from your trading account. I have had clients who have thought they had a loss in their trading account for the year, only to examine the wash sales they have had and realize that they have had a paper gain, although their cash flow does not show it.

REMEDY: The only remedy, other than staying on the sideline in our favorite stock(s) during the complete month of December, for those of us who trade the same stocks and options throughout the year is to claim the mark to market method of accounting. This election can only be filed for by those of us who trade as a business, either a sole proprietor (traders status) or in a formalized business such as an LLC or partnership. When we use the mark to market method of accounting it does away with the wash sales. However, as in anything there are pros and cons as to whether you want to take this election.

Next time we will go more in depth on both Traders Status and Mark to Market.

If you have questions about your taxes with respect to your trading, as a subscriber to this newsletter please send an email to the address below, and you will receive a personal answer within two business days.

Jim Crimmons

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