The character of income or loss associated with the sale exchange, exercise, or lapse of an option takes on the character of the property to which the option relates. If the debt to which the options relate is a capital asset in the hands of the taxpayer, then the gain or loss from the option will also be capital. Thus, traders and investors who allow an option to expire will have a capital loss in the amount of the premium paid for the option. Gain or loss from a credit put option will be ordinary in character to dealers for which the option is “security” in the hands of hedge of ordinary property held by the dealer.
As lenders and other investors increase their use of credit derivatives to manage credit risk or to synthetically invest in existing debt instruments, it becomes increasingly important that the US federal tax system resolve any uncertainties with respect to the taxation of credit derivatives. The rules governing credit derivatives tend to be quite complex. Tax issues such as timing, character, and source of income should be carefully considered before entering into a credit derivative contract. Overlooking tax implications of certain terms of any financial product could jeopardize the contracting parties’ ability to achieve their intended financial goals. Financial practitioners should consult a tax professional when designing or investing in complex forms of financial products.