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All interest income (including imputed interest) must go on 1040 line 2 taxable interest. For example, if the interest rate is 5%, then I can buy 100 T-Bills for $95 each. After 1 year I get $100 per T-bill, so there is $5 imputed interest for each T-bill.

Similarly, I can buy 100 shares of AMZN, sell one $100 call contract expiring 1 year from now, and buy one $100 put contract expiring on the same date. (In other words, I get 100 shares, and the right plus obligation to exchange each one for $100 one year from now). If the risk-free interest rate is 5%, then I pay net $95 per share because I am paying now for a guaranteed $100 per share in one year. (Note: this is a simple example because AMZN does not pay dividends or HTB interest).

From an investment standpoint, both investments function similarly. In both cases the imputed interest is 5% and therefore putting $10K in either investment results in $500 on 1040 line 2. However I could not find specific literature on how the IRS calculates taxable interest on options trades. Does the broker automatically generate a 1099-INT? Does their calculation work one leg at a time, or is it only done for pure-interest strategies?

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  • Perhaps I'm missing something, but options do not pay "interest", they are priced at a discount purely because of TVM. So the gain would be a capital gain when the trade expires. Are you trying to create an option basket to offset interest income as per your previous question?
    – D Stanley
    Mar 29, 2023 at 18:42
  • @D Stanley It seems you're saying "options don't pay interest, they pay [imputed interest]". Wherein "imputed interest" is defined as "discount purely because of TVM". One could argue that they're different, but the IRS generally treats imputed interest the same as any other interest. (certainly for T-bills, and also the answer to the linked question suggests that any form of interest is taxed on 1040 line 2). Mar 29, 2023 at 18:46
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    I am not aware of any IRS regs that treat this type of option scenario as "imputed interest". From a tax standpoint you would have three separate trades that would have a net total capital gain of $500. Just because it is a risk-free gain at the rate of interest does not make in "interest income". It would be capital gains.
    – D Stanley
    Mar 29, 2023 at 18:50
  • So maybe to answer the question in the final sentence, the gains and losses are computed by trade and then summarized in a 1099-DIV
    – D Stanley
    Mar 29, 2023 at 18:51
  • @D Stanley Are you saying that I can legitimately get a risk-free gain and then just deduct unrelated capital loss carryover from it? But then why would anyone buy T-bills? Mar 29, 2023 at 18:54

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Just because the net P/L of the trade basket is effectively capital gains at the risk-free interest rate does not make it "interest". T-bill gains are traded as interest because they trade at a discount in lieu of paying interest (which would be the "normal" source of income from a debt instrument). Options do not pay interest, but are priced at a discount purely because of TVM and arbitrage pricing theory, so there is no concept of "netting out" the gains of this basket and treating is as "interest".

In short, the P/L of each trade would be computed individually, classified as capital gains/losses, and then netted out in a 1099-DIV.

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  • Thank you for explaining the underlying concepts. So interest is only for debt instruments. Could the IRS argue that a put option is a debt instrument? After all, isn't such a contract just a right to be repaid in the future? Mar 29, 2023 at 19:15
  • I'm not a tax law expert, and "interest is only for debt instruments" may be overly simplistic; from a tax standpoint, "interest" is whatever the tax law says it is. If congress wanted to change tax law to classify part of the time value of options as "interest" then it could do so. But it's unlikely that it would introduce such complexity for seemingly little benefit.
    – D Stanley
    Mar 29, 2023 at 19:23

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