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Nearly all of the information that I can find online on option exercise and taxes are related to employee stock options, where you do get taxed on the gain (even if on paper) between the strike price and the FMV.

What is the tax treatment if I exercise an ITM option that I purchased on the open market?(Standard call option, 1 contract = 100 shares.)

As an example, assume that I purchased one July 2021 call option for stock XYZ at a strike price of $30, paying a premium of $3. Suppose the stock is now worth $50 and the option is trading around, let’s say, $20.

I can sell the option and capture a gain of $1700 (paying taxes appropriately as ST/LT depending on holding period.) What happens if instead I pay $3000 to exercise those shares? I now have 100 shares that are worth $5000, with my basis as $3300.

  • Will I have to pay the taxes on the gain immediately like with ISOs or only when I dispose the shares?
  • Will my ST/LT clock reset to the exercise date or does my option purchase date transfer over?
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Will I have to pay the taxes on the gain immediately like with ISOs or only when I dispose the shares?

Only when you sell the shares (and only if there's a gain)

Also note that you wouldn't pay taxes "immediately", but when you file (or sooner if you need to make quarterly estimated payments), and that gain may end up being offset by compatible losses in other investments.

Will my ST/LT clock reset to the exercise date or does my option purchase date transfer over?

The holding period for the stock begins when you exercise the option to acquire the stock, not when you bought the option. Otherwise I could see a loophole of buying a slightly OTM option with a one-year expiry, then acquiring the stock and selling quickly for short-term gain if the stock becomes ITM.

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    You are right about the holding period restarting on the exercise date, but it's not to avoid creating a loophole - it's actually a classic "trap for the unwary": if the taxpayer holds the option for more than a year and sells it, any gain or loss is long term; if, on the other hand, he exercises the option and immediately (or less than a year later) sells the underlying shares, any gain or loss is short term - despite the fact that the economics are essentially the same.
    – Jack Fleeting
    Jun 10, 2021 at 15:25

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