The tax treatment of stock options depends on which kind you hold. Incentive stock options (ISOs) trigger no regular income tax at exercise and can qualify the entire gain for long-term capital gains rates. Non-qualified stock options (NSOs) generate ordinary income the moment you exercise. Options bought and sold on public exchanges follow capital gains rules, with the rate depending on what you traded and how long you held it. The gap between these regimes is wide enough that applying the wrong one can cost thousands at filing time.
How ISOs Are Taxed
ISOs get the most favorable treatment of any employee stock compensation. Nothing happens on your return at grant. Nothing happens at vesting. Even when you exercise and buy the shares at your strike price, you owe no regular federal income tax on the spread between the strike and the market value.1Office of the Law Revision Counsel. 26 U.S.C. 421 – General Rules
The condition is holding the shares long enough afterward. For long-term capital gains treatment on the eventual sale, you need to hold the stock at least two years after the grant date and at least one year after the exercise date.2Office of the Law Revision Counsel. 26 U.S.C. 422 – Incentive Stock Options Meet both, and your entire profit from grant price to sale price is a long-term capital gain, topping out at 20% federal in 2026 instead of the 37% ordinary income ceiling.
Disqualifying Dispositions
Sell before hitting either holding period and you have a disqualifying disposition. The spread between your exercise price and the fair market value on the exercise date gets reclassified as ordinary income. If you sold for less than the exercise-date market value, the ordinary income amount is capped at your actual gain on the sale. Your employer reports this income on your W-2 for the year of the sale, but ISOs stay exempt from Social Security and Medicare withholding even when the disposition is disqualifying.
The AMT Trap
Here is where ISOs get complicated. Although the spread at exercise escapes regular income tax, it counts as an adjustment for the alternative minimum tax.3Office of the Law Revision Counsel. 26 U.S.C. 56 – Adjustments in Computing Alternative Minimum Taxable Income Exercise a large block when the stock has run up, and the AMT adjustment can push you into AMT territory. For 2026, the AMT exemption is $90,100 for single filers and $140,200 for married couples filing jointly, with phaseouts beginning at $500,000 and $1,000,000, respectively.4Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 If your spread exceeds those numbers, run the AMT calculation on Form 6251 before deciding how many shares to exercise in a single year.
How NSOs Are Taxed
NSOs are the more common form of option compensation, and the tax rules are simpler but less generous. The moment you exercise, the spread between your exercise price and the stock’s fair market value counts as ordinary compensation income.5Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection With Performance of Services Your employer includes it in Box 1 of your W-2 and reports it separately in Box 12 with code V.6Internal Revenue Service. Publication 525 – Taxable and Nontaxable Income
Unlike ISOs, NSO income carries full payroll taxes. Your employer withholds Social Security (6.2%) on the spread up to the 2026 wage base of $184,500, counting your other wages first.7Social Security Administration. Contribution and Benefit Base Medicare (1.45%) applies to the whole amount with no cap. If your total wages exceed $200,000, the additional 0.9% Medicare tax kicks in on everything above that threshold.
After exercise, your basis in the shares equals the exercise price plus the ordinary income already recognized. From that point forward, the shares are just stock. Hold longer than a year past exercise and any further appreciation qualifies for long-term capital gains rates. Sell sooner and the additional gain is short-term. This is where people leave money on the table: exercising and immediately selling makes the entire profit ordinary income, while waiting twelve months converts the post-exercise growth into a long-term gain.
Section 83(b) Elections for Early Exercise
Some companies let employees exercise options before they vest. Early-exercise NSOs on unvested shares without taking any special action, and you won’t owe tax at exercise. You’ll owe ordinary income tax later, when the shares vest, on the spread at that future vesting date. If the price climbs between exercise and vesting, your tax bill climbs with it.
A Section 83(b) election lets you lock the tax hit in at the current value. You pay ordinary income tax now on the spread at early exercise, and any future appreciation after that point can qualify for capital gains treatment. The deadline is strict: submit the election to the IRS within 30 days of the stock transfer, with no extensions.8Internal Revenue Service. Form 15620 – Section 83(b) Election Miss that window and you’re stuck with the default, with no way to file retroactively.
The risk is real. If the stock drops after you file, or you leave the company and forfeit unvested shares, you’ve paid tax on income you never received and can’t get it back. The election makes the most sense when the spread at exercise is small and you expect significant appreciation before vesting.
How Traded Call and Put Options Are Taxed
Options you buy and sell on public exchanges have nothing to do with employer compensation. Under federal law, gains or losses from traded options take on the same character as the underlying asset the option relates to.9Office of the Law Revision Counsel. 26 U.S.C. 1234 – Options to Buy or Sell Since most equity options are held for well under a year, the gains are typically short-term capital gains taxed at ordinary income rates.
If an option you bought expires worthless, you have a capital loss equal to the premium you paid; the law treats it as if you sold on the expiration date. If you close the position before expiration through an offsetting trade, the gain or loss is the difference between what you paid and what you received, recognized in the year you closed the trade.
When you exercise a call, the premium you paid gets added to your cost basis in the stock you purchase. When you exercise a put, the premium reduces your sale proceeds from the stock you sell. The premium doesn’t generate a separate taxable event; it folds into the stock transaction.
Writing Options
If you write (sell) options rather than buy them, the rules flip. For the writer, any gain from a closing transaction or from the option expiring worthless is a short-term capital gain, regardless of how long the position was open.9Office of the Law Revision Counsel. 26 U.S.C. 1234 – Options to Buy or Sell Covered call writers who collect premiums on expiring options always report the income as short-term gain.
If you write a put that gets assigned, the premium you received reduces your cost basis in the stock you’re forced to buy. If you write a call that gets assigned, the premium increases your sale proceeds. In either case, the holding period of the underlying stock determines whether the resulting transaction is short-term or long-term.
Section 1256 Contracts and the 60/40 Rule
Not every traded option follows the standard rules. Options on broad-based stock indexes (like the S&P 500), regulated futures contracts, and foreign currency contracts fall under Section 1256.10Office of the Law Revision Counsel. 26 U.S. Code 1256 – Section 1256 Contracts Marked to Market Single-stock equity options are excluded; the treatment applies only to nonequity options, meaning options whose value is not tied to individual stocks or narrow-based stock indexes.
Section 1256 contracts get two unusual features. They are marked to market on the last business day of the year: even if you still hold the position on December 31, you report any unrealized gain or loss as if you had sold at the closing price. And all gains and losses, no matter how briefly the contract was held, are automatically split 60% long-term and 40% short-term. That blended rate is meaningfully better than the straight short-term rate that applies to most equity options held under a year.
Loss Carryback
Section 1256 contracts also come with a loss carryback that other investments don’t get. A net loss on Section 1256 contracts for the year can be carried back to any of the three preceding tax years, but only against Section 1256 gains in those years.11Office of the Law Revision Counsel. 26 U.S. Code 1212 – Capital Loss Carrybacks and Carryovers The carried loss keeps its 60/40 character, and you apply it to the earliest eligible year first. That can generate a refund of taxes already paid, which matters during a bad year for index options or futures.
Wash Sales for Option Traders
The wash sale rule catches option traders more often than most realize. If you sell a stock or option at a loss and buy substantially identical securities within 30 days before or after the sale, the loss is disallowed.12Office of the Law Revision Counsel. 26 U.S.C. 1091 – Loss From Wash Sales of Stock or Securities The statute specifically covers “contracts or options to acquire or sell stock or securities,” so buying a call on the same stock you just sold at a loss can trigger it.
The disallowed loss isn’t gone. It gets added to the basis of the replacement security, so you’ll recover the benefit when you sell the replacement, and the original holding period carries over. Where this becomes a headache is active trading. Rolling options on the same underlying week after week can create cascading wash sales that are painful to untangle at tax time. Your broker tracks some of this on Form 1099-B, but not all scenarios — particularly those across different accounts or between stock and options — get caught automatically.
The 3.8% Net Investment Income Tax
Capital gains from options don’t stop at federal income tax. If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), you owe an additional 3.8% Net Investment Income Tax on the lesser of your net investment income or the amount by which your income exceeds those thresholds.13Office of the Law Revision Counsel. 26 U.S.C. 1411 – Imposition of Tax Those thresholds are not inflation-adjusted, so they reach more taxpayers every year.
The surtax applies to capital gains from traded options, gains from selling stock acquired through NSO exercises, and gains from qualifying ISO dispositions. The spread recognized as ordinary compensation income when you exercise NSOs is not subject to NIIT because it’s already treated as wages, but any post-exercise appreciation on those shares is investment income. A large ISO exercise that generates AMT liability can also push your modified AGI above the NIIT threshold, compounding the hit in a single year.
Reporting Option Transactions
The reporting is tedious rather than difficult once you know which forms apply.
Forms You Receive
Your brokerage sends Form 1099-B reporting proceeds and cost basis for every option and stock sale during the year.14Internal Revenue Service. Instructions for Form 1099-B If you exercised ISOs, your employer files Form 3921, which shows the exercise price per share in Box 3 and the fair market value per share on the exercise date in Box 4.15Internal Revenue Service. About Form 3921 – Exercise of an Incentive Stock Option Under Section 422(b) The difference is your bargain element for AMT purposes. Employees in employee stock purchase plans receive the analogous Form 3922 for ESPP share transfers.16Internal Revenue Service. Form 3922 – Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c) NSO income appears on your regular W-2 in Boxes 1 and 12 (code V).6Internal Revenue Service. Publication 525 – Taxable and Nontaxable Income
Forms You File
Each individual sale goes on Form 8949, listing the date acquired, date sold, proceeds, and cost basis for every transaction.17Internal Revenue Service. Instructions for Form 8949 The totals flow onto Schedule D of your Form 1040. Exercised ISOs during the year also require Form 6251 to calculate any AMT on the bargain element.18Internal Revenue Service. Instructions for Form 6251 Option-related ordinary income that doesn’t appear on a W-2, such as NSOs received as a non-employee, gets reported on Schedule 1, Line 8k.19Internal Revenue Service. Schedule 1 (Form 1040)
The most common reporting mistake is double-counting income. Your employer includes NSO spread income on your W-2, and your broker also reports the full sale proceeds on Form 1099-B. You need to adjust the cost basis on Form 8949 to reflect the income already taxed as wages, or you’ll pay tax on the same dollars twice. Cross-referencing your W-2 Box 12 code V amount against your 1099-B cost basis entries is the fastest way to catch it before filing.