How does the IRS calculate a capital loss on stock options?

Not every startup experiences a successful exit, and not every employee who exercises their stock options ultimately makes money.

If you find yourself underwater on your exercised stock options, there is a small silver lining — if you decide to sell them at a loss, you can use that loss to offset other income or capital gains you made elsewhere that year.

Note: The IRS calculates your cost basis for capital gains/losses differently, depending on if you exercised ISOs vs. NSOs. More on that below.

Capital losses on ISOs

To calculate a capital loss on incentive stock options (ISOs), you’ll report the difference between your strike price and the price you ultimately sell your shares for. This difference — whether it’s positive or negative — is also known as your “spread.”

For example, let’s say you’re a tech worker in California who earns a $100,000 annual salary. You exercise 50,000 ISOs for $5 per share, paying your company $250,000 in the process (Note: Let’s temporarily put aside the company’s 409A valuation, or any related AMT taxes you owe at exercise).

Later, the company goes public but the stock price tanks, falling to $3 per share. You sell your shares, and report to the IRS a capital loss of $100,000 ($250,000 cost basis to buy the shares - $150,000 sale proceeds).

You can now use that $100,000 capital loss to offset up to $3,000 of capital gains (or ordinary income) you experienced elsewhere that tax year. Every year going forward, you can continue to deduct up to $3,000 from this capital loss until it’s gone.

Separately, if you paid AMT taxes when you exercised your ISOs, you can gradually get that money back in future tax years through the AMT credit.

Capital losses on NSOs

Calculating capital losses on NSOs is slightly different.

For example, let’s say you’re a tech worker in California who earns a $100,000 annual salary. You exercise 50,000 NSOs for $5 each, on a day when the company’s 409A valuation (also known as fair market value) stands at $10 per share.

It costs you an estimated $359,000 to exercise your stock options. Why?

You’ll pay $250,000 to purchase the shares (50,000 shares x $5 per share strike price), and an estimated $109,000 in additional income taxes on the assumed gain of $250,000 (50,000 shares x $10 per share fair market value).

Later, the company goes public and the stock falls to $3 per share. You sell all of your shares, and report a capital loss of $350,000. This amount is the difference between the fair market value of your shares on the day you exercised them, ($500,000) and your ultimate sale price value ($150,000).

You’ll be able to use this capital loss as a tax deduction in the future, reducing up to $3,000 in capital gains or income per year until it’s exhausted.

Want to learn more about stock options? Check out our educational resources at Secfi Learn.