Tax Treatment of Synthetic Long Options Strategy: IRS Rules and Reporting

You're right to question this. The tax treatment of synthetic longs can be tricky because they're economically equivalent to stock ownership but are treated as separate transactions for tax purposes. In your second scenario, you're essentially recognizing the loss on the call option while acquiring stock through the put assignment. This technically isn't considered a wash sale by the IRS because options and their underlying stocks are not considered "substantially identical securities" in all circumstances. However, there are some important nuances here. The key is whether the option is "deep in the money" - if it is, the IRS might consider it substantially identical to the stock. Since your options were at-the-money when opened, they might not trigger wash sale rules, but this is definitely a gray area. Your brokerage is correctly reporting each leg of the transaction separately: the loss on the call and the acquisition of stock through the put. This does create a timing advantage as you noted - immediate loss recognition while deferring gain until stock sale.

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I was initially skeptical about taxr.ai when I saw it mentioned here, but after struggling with my own synthetic positions and having my CPA give me contradictory advice, I decided to give it a try. Really glad I did. The system correctly identified my synthetic long position as a single economic strategy rather than separate transactions. It provided clear documentation explaining that while the brokerage reports each leg separately, the proper tax treatment should consider the economic substance of the transaction. For my situation (similar to yours), they provided a detailed explanation of why wash sale rules shouldn't apply in most cases, with references to specific tax rulings. The documentation was comprehensive enough that my CPA changed his position after reviewing it. Best of all, they identified several instances where my brokerage's reporting would have caused me to overpay on taxes. Definitely worth checking out if you're doing complex options trading.

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You might need to look at Rev. Ruling 85-87, which specifically addresses wash sales with options. The IRS states that a loss from selling stock can be disallowed if you acquire an option to purchase substantially identical stock within the wash sale period. But they don't clearly state the reverse - whether an option loss is disallowed when acquiring the stock. Most tax professionals I've talked to interpret this conservatively, treating a loss on options followed by stock acquisition as a potential wash sale. Your scenario is slightly different since the stock acquisition happens through put assignment rather than a direct purchase. In practice, many brokerages don't flag these as wash sales, but the IRS could potentially challenge this treatment.

I see a lot of people suggesting the conversion of an option to stock through assignment might trigger wash sale rules, but I'm not sure that's correct. Publication 550 specifically states that wash sales apply when you sell stock or securities at a loss and buy "substantially identical" stock or securities. The key is whether a call option and the underlying stock are "substantially identical" - and most tax professionals I've worked with don't consider them to be unless the options are deep ITM. Your ATM options likely wouldn't qualify as substantially identical. My CPA has always treated synthetic longs exactly as your brokerage is reporting them - separate transactions with different tax treatment for each leg.

The confusion around "substantially identical" securities is understandable because the IRS hasn't provided crystal clear guidance specifically for synthetic options strategies. However, there are some key distinctions that might help clarify things. The general rule from Revenue Ruling 58-384 is that options and their underlying stocks are NOT considered substantially identical securities for wash sale purposes, unless the option is so deep in-the-money that it's essentially equivalent to owning the stock itself. Since your options were at-the-money when opened, they likely wouldn't meet this "deep ITM" threshold. The timing issue is also important - in your case, you didn't sell stock at a loss and then buy an option. Instead, you had an option expire worthless and simultaneously acquired stock through assignment of another option that was part of the same synthetic strategy from day one. That said, given the complexity and the fact that synthetic longs are designed to replicate stock ownership, I'd recommend keeping detailed documentation of your investment rationale (beyond tax considerations) and consider consulting with a tax professional who specializes in options strategies if you're using this approach frequently. The current treatment by your brokerage appears to follow standard practice, but having professional backup never hurts with complex strategies.