As with most tax cuts, the dividend-tax cut brought good news for a lot of people and confusion to virtually everyone. This recent cut seems deceptively simple: Dividends are taxed at 15%, 5% if you're in the bottom brackets. But if you remember nothing else, remember that nothing in the tax code is ever that straightforward, and exceptions abound. (All dividends not eligible for the 15% rate will be taxed at the investor's ordinary income tax rate -- which could be 25%, 28%, 33% or 35%.) So for those of you a bit befuddled over the do's and don'ts, today's Financial Education column offers a roundup of what investors in dividend-paying securities need to know come tax time.
Borrowed StockNeither a borrower nor a lender be -- at least, not if you want to be eligible for the reduced tax rate on dividends. Dividends on borrowed stock will not be eligible for the reduced rate, and you're also out of luck if you're lending the stock. Also, substitute payments to stock lenders from stock borrowers (short-sellers) in lieu of a dividend, with respect to stock on loan in a short sale, will also not be eligible. In other words, lenders will not be eligible for the reduced rate because they're not actually getting the dividend. Instead they're getting a payment that's equal to the dividend from the investor who has borrowed the stock.
Borrowed FundsIf the investor is claiming an interest deduction for the loan, the dividends on stock purchased with borrowed funds will not be eligible for the lower rate. But taxpayers can "double-dip" on stock purchased with borrowed money and take an interest deduction for the investment loan if they have investment income from other sources. So if a taxpayer has income from bonds, REITs or dividends that aren't eligible for the reduced rate, the IRS will allow a deduction in the amount of that income, and permit the taxpayer to apply the reduced tax rate on dividends that do qualify. The amount of the investment interest deduction is limited to net investment income. If the interest on an investment loan exceeds net income for that year, taxpayers can carry over the remainder of the deduction to use in future years.
Holding PeriodTypically, investors in dividend-paying stocks must hold the stock until a specified date in order to receive the upcoming dividend payment. Now, under the new tax law, you must hold the stock for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the first trading day after the eligibility date). If you, or a fund manager, own the stock for 60 days or less during the two months before and after the ex-dividend date, all dividends will constitute ordinary income and be taxed at your regular rate.