HOW ARE OPTIONS TAXED?
An option to purchase a property, as the term implies, provides the holder of the option an optional right to purchase the property. The option is referred to as a call option. The purchase price under the option is sometimes called the exercise price or strike price.
Conversely, an option to sell a property provides the holder of the option an optional right to sell the property. The option is called a put option. The sales price under the option is also called the exercise or strike price.
If you purchase or acquire an option, there are generally no immediate tax consequences for you. Instead, the amount you paid for the option becomes your cost or “adjusted cost base” of the option.
The person granting the option (“grantor”) will include the amount they received for the option as proceeds of disposition, which will result in a capital gain (or, if they are in the business of granting or selling options, their profit will be business income). The grantor’s adjusted cost base of the option is deemed to be nil, such that the entire proceeds will constitute the capital gain, one-half of which is included as a taxable capital gain.
However, if the option is exercised, the tax consequences become more significant.
Exercise of call option
If you exercise a call option and acquire the property subject to the option, the amount you paid for the option will be added to your adjusted cost base of the property, plus of course whatever you paid for the property under the exercise price.
The grantor of the call option will add the amount paid to them for the option to their proceeds of disposition of the property. Since the amount paid to them for the option was initially a capital gain (see above), if the option is exercised in a subsequent year, the CRA can re-assess the grantor’s previous year to make the appropriate adjustments and effectively reverse that initial capital gain. (If the option is exercised in the same year in which it was granted, the adjustments are simply made in the return for that year.)
In year 1, John buys a call option from Sally for $5,000. The option gives John the right to purchase a property from Sally at an exercise price of $100,000 over the next two years. In year 2, John exercises the option and purchases the property for $100,000.
John’s adjusted cost base of the property becomes $5,000 plus $100,000, or $105,000.
In year 1, Sally initially reported $5,000 as a capital gain, half of which was a taxable capital gain included in her income. However, since the option was exercised in year 2, that initial capital gain will be reversed. Instead, Sally has proceeds of disposition for the property in year 2 of $105,000. She will have a capital gain or loss in year 2, depending on her cost of the property.
Exercise of put option
If you exercise a put option and sell the property under the option, you deduct your cost of the option from your proceeds of disposition of the property.
The purchaser of the property deducts the amount you paid for the option from their cost of the property. Since the amount paid to them for the option was initially a capital gain, if the option is exercised in a subsequent year, the CRA can re-assess the purchaser’s earlier year to make the appropriate adjustments.
In year 1, Bela pays Ahmed $5,000 for a put option. The option gives Bela the right to sell a property to Ahmed for $100,000 over two years. In year 2, Bela exercises the option and sells the property to Ahmed for $100,000.
Bela’s proceeds of disposition of the property are reduced by her $5,000 cost of the option, to $95,000. She will have a capital gain or loss, depending on her cost of the property.
In year 1, Ahmed will report $5,000 as a capital gain. However, since the option was exercised in year 2, that initial capital gain is effectively reversed. Instead, the $5,000 reduces his cost of the property in year 2, which becomes $95,000.
If you have an option and do not exercise it so that it expires, there is a deemed disposition at the time it expires. Since you will have nil proceeds of disposition (since the option simply expired and so you got nothing for it), you will have a capital loss, which will equal your cost of the option.
Assume the same facts as Example 2, except that Bela’s option expires at the end of year 2.
In such case, since she has nil proceeds on the expiration, but since her cost of the option was $5,000, she will have a capital loss of $5,000, half of which will be an allowable capital loss claimable against her taxable capital gains.
On a final note, there are different rules that apply to employee stock options.