Avoid audits when trading options

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The US tax code is a complex maze. It is 73, pages long and includes more than 1, different publications and tax forms. In order to win in the tax game, you need to have the proper knowledge and expertise that can help you reduce your tax liability and stay in compliance. In this 3 part option trades tax reporting, we are going to zoom in and focus on trader taxation laws and the top ten mistakes traders make when preparing their tax returns.

These mistakes lead to IRS audits, penalties and fines. These mistakes are costly and may cause you to pay thousands of dollars in unnecessary taxes. Not filing a tax return due to trading losses or minimal trading.

There are people who are under the impression that they are required to file a tax return option trades tax reporting if they had trading profits. Or, they are exempt from filing a tax return if they had a handful of trades, or experienced losses in the market. They are absolutely wrong! Failure to report your trading activity, even if you only had losses, or minimal gains may lead to IRS notices, penalties and interest. Take note that the IRS receives a copy of your from your brokerage company and if there is not a match between the trades on the form to the trades reported on your tax return they will send you a notice.

What is worse is that the IRS will assume that your total taxable profits equal your option trades tax reporting proceeds, and you will be taxed at the highest tax bracket allowable. In the last 13 years, I have seen many IRS notices like this, asking taxpayers to pay up to hundreds of thousands of dollars in taxes. The clients typically are astonished when they receive these alarming notices. In attempt to fully write option trades tax reporting their losses they report it on Schedule C. They claim that they are business traders and therefore they are allowed option trades tax reporting report their losses on Schedule C.

This is a sure way to get on the IRS radar. The IRS code and publications clearly states that all capital transactions must be reported on Schedule D. The remainder of the disallowed losses gets carried over to future years. Most traders are not aware of this election and fail to make it on time. The result of this notice will surely be additional tax liability, penalties and interest.

Avoid this mistake and consult with your trader tax professional on strategies you can use. Many traders elect to trade via a business entity such as a corporation, partnership or LLC.

When doing so they report all of their trading income as ordinary income and they subject their trading income to self employment tax. You should know that trading income is not considered to be earned income and only earned income is subject to self-employment tax. Therefore, reporting your gains as earned income subjects you to an additional Option trades tax reporting full members of futures exchanges are obligated to pay SE taxes on futures trading gains.

However, too many traders out there are paying SE taxes on these gains. If you think the Option trades tax reporting will correct this error for you, you are simply wrong. The IRS hardly ever corrects mistakes in their favor. Mixing up the tax treatment between securities, contracts, forex and options. Stocks, bonds, and mutual funds belong to the securities group and are taxed at the long term capital gain rate if held more than a year. If the position is held for less option trades tax reporting a year it is taxed at the short-term option trades tax reporting gain rate.

Which essentially is your ordinary income tax bracket. Securities are also subject to the wash sale rule unless you have elected MTM accounting. Not all brokers report Section contracts correctly, especially instruments that are not clearly designated as such including some E-mini indexes and options on those indexes. You need to make sure you are reporting your trades correctly and not missing on any tax breaks available to you.

You will need to know what tax election to make and when to make it. Failure to do so may cost you thousands of dollars in unnecessary tax payments.

Next week, we will continue with items on our top ten mistakes traders make when filing their taxes. Until then, have a successful week. To find option trades tax reporting more about how you can avoid audits, reduce taxes legally and keep more of your profits, please visit OTA Tax Pros http: Disclaimer This newsletter is written for educational purposes only.

By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial option trades tax reporting whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter.

Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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Ads keep this website free for you. Looking for US tax information? Look in our Directory. Stay Connected with TaxTips. However, if you are in the business of buying and selling stock, then your gains and losses from options will be treated as income on income account - see capital or income. When your options are treated as capital gains, their disposition is reported on Schedule 3 Part 3, where publicly traded shares are reported.

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. Usually, the taxpayer would benefit from filing the T1Adj. The only problem is that the Income Tax Act requires the options proceeds to either be added to the proceeds from the sale of shares call option , or deducted from the cost basis of shares purchased put option when the option is exercised.

This applies even if the proceeds were taxed in a previous year, and no T1Adj was filed to reverse this. Therefore, double taxation will occur if the T1Adj is not filed. During the year you sell 3 Put options of the same underlying and they expire out of the money. Based on the above table, each transaction should be treated as capital gain in the year sold. What if on the 4th option sold of the same underlying, you end up with the underlying shares?

Clearly you reduce the cost of the shares assigned by the value of the premium received on the 4th sale. BUT can you further reduce the cost of the shares by including the first 3 premiums collected if the shares are sold in the same year? Each sale of put options is a separate transaction, and not related to the next sale of put options. When the 4th option is exercised, the cost of the shares cannot be reduced by the premiums collected on the previous put options.

This is not affected by the timing of the sale of the shares. We traded options for about a decade, and in the end finally decided to quit, because. Leave option-trading to the professionals.

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Each person's situation differs, and a professional advisor can assist you in using the information on this web site to your best advantage. Please see our legal disclaimer regarding the use of information on our site, and our Privacy Policy regarding information that may be collected from visitors to our site. Timing of proceeds reported for tax purposes. Tax treatment when options are sold: Tax treatment when options are purchased: