What the Tax Cut Does and Doesn't

Investors have had some reason to celebrate of late -- not only did Congress dramatically reduce the tax on dividends individuals receive, it also lowered the tax on long-term capital gains. Both are now subject to a 15% tax.

But nothing about tax law is ever that simple, and the new rules have spawned several reader questions on a few topics. So, in the interest of clarity, let's target a few areas of common misconception.

Short-term capital gains. Much of the press surrounding this tax law has said that the tax on capital gains has been cut. That's only half true -- long-term rates have been cut from 20% to 15%. Only securities sold more than a year after you bought them will qualify for this rate, though. Short-term capital gains rates remain the same. That means that the profits on any securities sold a year or less from the time they were purchased will be taxed according to your ordinary income tax rate.

Also, the super-long-term rate on capital gains has been eliminated. Prior to the new law, any securities purchased after Dec. 31, 2000, and held for more than five years were to be eligible for an 18% rate. The new law doesn't provide any additional incentive for holding stocks, bonds or funds for anything longer than a year.

Real estate investment trusts (REITs). By definition, REITs do not pay corporate tax on their profits, and they must pass on 95% of their earnings to investors as dividends. Because of this structure, though, REIT investors will not be eligible for the 15% tax rate on REIT dividends -- rather, the rate will continue to be their ordinary income tax rate.

There are a few exceptions, though. If the REIT does pay tax on all or part of its profits, its dividend (or a pro-rated portion of it) will be eligible for the 15% rate once it's distributed to investors. Also, if the REIT has taxable subsidiaries that contribute to the dividend payout, that portion will be eligible for the 15% rate as well. And if any part of the REIT dividend is attributable to capital gains the REIT incurred, that portion will be eligible for the 15% tax. These exceptions are pretty rare, though, and most REIT investors can assume that the entirety of their REIT dividend payout will be taxed at their ordinary income tax rate.

Foreign stocks. Generally, if a foreign stock is traded as an ADR on a U.S. exchange, it will be eligible for the 15% dividend tax rate. The reduced rate, though, will not apply to dividends paid by foreign investment companies, passive foreign investment companies or foreign holding companies.

Some investors in non-ADR foreign stocks may still qualify for the 15% rate, though. Foreign companies based in U.S. territories (such as Puerto Rico or Guam) will be eligible, as will companies based in countries with favorable tax treaties with the U.S.

Investors in foreign stock mutual funds will be provided with an accounting of which portion of their fund's dividend payments are subject to the 15% rate and which will still be subject to their ordinary income tax rate.

Also, if an investor pays foreign tax on the dividends received (unlikely if it's from an ADR) and subsequently receives a foreign tax credit for the amount of tax paid, the amount of credit allowed will be adjusted to reflect the new U.S. rates.

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