Tackling how your portfolio options get taxed

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A friend of mine studied aerospace engineering at MIT a few years ago. That's right. He studied rocket science. He told me one time that rocket science really is that difficult – but the results (he's hoping to fly into space one day) are worth it. Investors can gain some idea of the complexity of rocket science by studying how the Canada Revenue Agency (CRA) taxes portfolio options. You know – puts and calls. I wrote last week about an options strategy to consider. This week, I want to talk about how the taxman will tax profits and losses on options strategies. The tax treatment, in a nutshell, will depend on the type of income, and the timing of the income you earn.

Type of income

Will your profits and losses from options strategies be taxed as capital gains and losses (referred to as "on capital account"), or business income and losses (on "income account")? It's an important question because just one-half of capital gains are subject to tax. Business income is fully taxable, although you may be entitled to claim some deductions against business income that you won't be able to deduct against capital gains. As a rule, if you're making profits, you'll likely prefer capital gains treatment.

The taxman's view is that your profit and losses from options strategies should be taxed on the same basis as transactions in the underlying securities. In most cases, investors will be taxed on capital account, not income account, but this will depend on factors that include the frequency of your transactions, period of ownership of a security, your knowledge of securities markets, time spent studying securities, whether trading securities is part of your regular business, whether you have borrowed to make your investments, whether you advertise your willingness to transact in securities and the nature of the securities.

You should be aware that there's something called the "Canadian securities election" in our tax law, which is an election you can make to treat all your transactions in Canadian securities as on capital account. Filing Form T123 is the way to make this election, but it's not available if you're a "trader or dealer" in securities. Further, the election is irrevocable, so you should think twice, and get advice, before filing it (in most cases your transactions will be treated on capital account anyway, so making the election may not be necessary). And when it comes to trading in put and call options, this election is not available.

I should mention that a writer of naked options will generally be taxed on income account, but capital gain or loss treatment may be accepted if you're consistent in how you report this from year to year.

Timing of income

The taxman will treat the taxation of your options strategies differently, depending on whether you're a writer or holder of the options, whether you're dealing with puts or calls and whether you're being taxed on capital or income account. As for the timing of your income, this will depend on when you acquire or sell the option, whether you exercise your option, allow it to expire, or close out your position. Sound complicated? It is. The only way to summarize the rules is by the accompanying table.

Consider an example. Sarah is the holder of a put option giving her the right to sell a certain number of XYZ Corp. shares for $40 a share until June 30. She paid a premium of $2,000 for this option, along with a commission to her broker of $85. On Feb. 20, Sarah exercises her option. She realizes that this will be a capital transaction in her hands, not an income transaction. How is she taxed? Have a look at the table.

As the holder of a put option taxed on capital account, Sarah's costs of acquisition (COA) totalling $2,085 will be deducted from her proceeds of disposition (POD) on the sale of the XYZ Corp. shares at $40. If Sarah had held the option until its expiry, she'd be entitled to claim a capital loss for the $2,085 COA in the year the option expires.

And if Sarah had instead closed out her position by selling the option on the open market, the premium she would have received on the sale, net of the COA of $2,085, would have been reported as a gain (or loss) in the year of closing out.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.