Qualified Dividends

Qualified Dividend Income
The value of a dividend paid by a domestic corporation or a qualified foreign corporation to a taxpayer between January 1, 2003 and December 31, 2010 will be recognized by the Internal Revenue Service as qualified dividend income thereby making it eligible for a lower ; this is the reason such income is labeled qualified dividend income. Qualified dividend income is taxed in 2007 at a 5% rate for taxpayers in the 10% and 15% tax brackets and at a 15% rate for those in the 25%, 28%, 33%, and 35% . In 2008 through 2010, a 0% rate will apply to taxpayers in the 10% and 15% tax brackets; the rates for taxpayers in the 25%, 28%, 33%, and 35% tax brackets will remain at 2007 levels.

A domestic corporation is a corporation created or organized in the U.S. A qualified foreign corporation is a non-domestic corporation other than a passive foreign investment company that is domiciled in a U.S. possession or territory or eligible for the benefits, including an exchange of information program, of a comprehensive income tax treaty with the U.S. A dividend from a foreign corporation is also a qualified dividend if it is paid on stock or an anti-deferral regime (ADR), and the stock or ADR is traded on an established U.S. securities exchange.

Ordinary Dividend Income
In contrast, the value of a dividend paid by a nonqualified corporation–that is, any corporation not a domestic corporation or a qualified foreign corporation–is classified as ordinary dividend income and taxed at ordinary income rates. Dividend income is defined broadly as the value of any distribution of money or property to a shareholder that is paid out of a corporation’s current earnings and profits or those accumulated after February 28, 1913. If a dividend is paid in cash, the amount of dividend income is obviously the amount of cash distributed to a shareholder. Likewise, the amount of dividend income for a distribution of property–a dividend paid in a form other than cash–is the property’s fair market value. In the process of calculating taxable income from a dividend distribution, the category of property includes all stock–but not a stock dividend from the distributing corporation unless it is of a class different than that on which the dividend is declared–and any economic benefit, regardless of form, a corporation provides to a shareholder, including payments to reduce a shareholder’s debt.

Holding Period Requirements for Dividends Paid on Qualified Stock
The fact that dividends are paid by a domestic or a qualified foreign corporation is a necessary, but not sufficient, condition for favorable tax treatment; for dividends to count as , the taxpayer must also pass the tests–or avoid the traps–listed below.

  1. The common stock of a domestic or a qualified foreign corporation is held for at least 61 days in a 121-day period beginning 60 days before the stock’s ex-dividend date. The holding period requirement is cumulative, that is, the 61-day period doesn’t have to be consecutive. (Note: A stock goes ex-dividend on the first day after a dividend is declared; in the period of time a stock is ex-dividend, the dividend is paid to the seller, not the buyer, of the stock.) Importantly, a taxpayer doesn’t receive credit towards the minimum 61-day holding period for common stock any day her risk of loss is diminished. Specifically, the risk of loss in connection with the qualified stock a taxpayer holds is diminished any day she has, or is bound by, a call option, a put option, or an open short sale contract (viz., a short sale made but not closed) for substantially identical stock or securities. In addition, risk of loss is diminished not only if the taxpayer is a writer of a call or put option for essentially identical stock or securities but also on any day she holds a position in substantially similar or related property. (Note: In figuring the number of days in a stock’s , count the day of disposal but not the day of acquisition.)
  2. The preferred stock of a domestic or a qualified foreign corporation is held for at least 91 days in a 181-day period beginning 90 days before the stock’s ex-dividend date and the dividend is attributable to a period of more than 366 days. As with common stock, the holding period doesn’t have to be consecutive nor does the taxpayer receive credit towards the minimum 91-day holding period for preferred stock any day her risk of loss is diminished.
  3. Any portion of a dividend that is treated as investment income in order to justify a investment interest deduction is not a qualified dividend.
  4. Dividends from a tax-exempt organization or a farmers cooperative are not eligible for qualified dividend income treatment.
  5. Any payments in lieu of dividends made by the taxpayer, as a short-seller, to compensate the lender of the otherwise qualified stock in a short sale transaction do not count as qualified dividends.

A dividend paid to a taxpayer by means of a pass-through entity such as a mutual fund or other regulated investment company, real estate investment trust, partnership, or a common trust fund is also eligible for the favorable capital gains rate if the distribution would otherwise be classified as qualified dividend income.

The reduced capital gains tax rate a taxpayer enjoys for qualified dividend income does not apply to dividend distributions from tax-deferred retirement vehicles such as deferred annuities, individual retirement accounts, 401(k) plans, and employer stock held on the date of record in an employee stock ownership plan that is maintained by the employer corporation. Moreover, the value of a dividend received from a building and loan association, credit union, mutual insurance company, mutual savings bank, or a nonprofit voluntary employee benefit association is not considered qualified dividend income and will be taxed at ordinary income rates.

Supplementary relevant articles on qualified dividends are listed below:

Many happy returns, Roger

Capital Loss

A taxpayer can lighten his tax burden by using a to lower, perhaps even eliminate, a net capital gain. If the capital loss is larger than the capital gain, then a taxpayer can use the excess to reduce up to $3,000 of ordinary income ($1,500 for a married taxpayer filing separately). Next, if a capital loss remains after the , the remainder can be carried forward to future tax years only if it is larger than the $3,000 maximum; to permit a taxpayer to transfer a smaller capital loss amount to future years would result in a double tax benefit. Finally, a carryforward retains its character as a or a .

Example 1: At the end of the year, Sally Davis, a single taxpayer, uses a $15,000 short-term capital loss to offset a $10,000 long-term capital gain. She then uses $3,000 of the remaining loss to reduce her ordinary income. Since the $2,000 capital loss that now remains is less than the maximum $3,000 capital loss deduction, she is not eligible for a .

In effect, the capital loss deduction creates a “phantom” capital gain (but not to exceed $3,000) a taxpayer can use to reduce ordinary income. Consistency, namely, double entry bookkeeping, demands that this year’s phantom capital gain be offset in the next. In short, to balance the books in this possible world, an offsetting entry in the successor year must be made, and it is this entry–a phantom reduction of long-term capital gain–that would produce a double tax benefit.

Example 2: Assume Davis’ long-term capital gain for the year is $5,000, not $10,000. First, she could use $5,000 of her $15,000 short-term capital loss to mark down the long-term capital gain to zero. Next, she could take full advantage of the capital loss deduction and lower her ordinary income by $3,000. Since the remaining $7,000 short-term capital loss ($15,000 - $5,000 - $3,000 = $7,000) is larger than the maximum $3,000 capital loss deduction, she is permitted to carry forward indefinitely $4,000 of the remainder ($7,000 - $3,000). Finally, the would would retain its short-term character.

Like its capital gain counterpart, a capital loss is good only for capital assets–for the most part, assets other than inventory and stock in trade, receivables, and real and depreciable property used in a trade or business. I say “for the most part” because the income tax treatment of assets, capital and non-capital, is riddled with exceptions: click on for a full explanation.

Additional relevant articles on the concept of capital loss are listed below:

Many happy returns, Roger

Real Estate Capital Gains

Sale of a Personal Residence
An individual may exclude up to $250,000 of the gain on the sale of a personal residence; the gain exclusion is $500,000 for joint filers. The gain exclusion may be used once every two years. Any gain in excess of the applicable exclusion amount is treated as a capital gain. A loss on the sale of a personal residence is not deductible.

To qualify for the gain exclusion, the taxpayer must pass an ownership and use test, that is, in the five-year period leading up to the date of sale, the taxpayer must have owned and used the property as a principal residence for at least two years. There is no requirement that the two-year period run consecutively but it must, in the aggregate, total 730 days (365 days per year x 2 years) in any five-year period. A vacation or a seasonal leave is a “short temporary absence,” and this type of absence counts as a period of use. Unfortunately, in federal income tax law, a difference in degree may be viewed as a difference in kind, and an absence of an entire year is too long a period of time for the label, “short temporary absence.”

In addition, even if the taxpayer is unable to meet the ownership and use test or the minimum two-year holding period, she can still claim a reduced exclusion if the primary reason for selling a residence is the occurrence of one or more of the following events:

To invent a new phrase, these “reduced exclusion events” are the safe harbors that make it possible for a taxpayer to take advantage of the reduced gain exclusion; in technical terms, a reduced exclusion event is thought to result in a sale of the residence. The reduced gain exclusion is calculated by multiplying the maximum allowable exclusion ($250,000 for a single taxpayer or $500,000 for a joint filer) by a fraction with a numerator equal to the lesser of (1) the period of time the taxpayer owned and used the property as a principal residence or (2) the amount of time elapsed between the taxpayer’s prior use of the gain exclusion and the date of the reduced exclusion event. Depending on the measure of time used in the numerator, the denominator of the fraction is either 24 months or 730 days.

If the taxpayer doesn’t satisfy the safe harbor test, relief may be available under a facts and circumstances test. In this test, the Internal Revenue Service will determine the principal reason for the sale by looking at (1) events leading up to the sale, (2) the taxpayer’s financial responsibility to maintain the property, and (3) material changes in the taxpayer’s life that would affect the suitability of the property as a primary residence.

An allocation of the gain exclusion is not mandated if the home, as a single structure, doubles as a personal residence and a business or investment property. However, the gain exclusion is reduced for any depreciation taken after May 6, 1997 on the property.

A member of the military, the foreign service, or an intelligence agency who is on active duty away from home has the option to suspend the aggregate two-year holding period requirement for the sale of one residence. The suspension is good for up to ten years. But a taxpayer who acquires a personal residence in a like-kind exchange must own the property for at least five years to qualify for the gain exclusion. For more information on the gain exclusion for a sale of a personal residence, click on (pdf file) and .

Sale of Subdivided Real Estate
Favorable tax treatment is also available for an individual who sells subdivided real estate. In particular, a gain on the sale of a subdivided lot or parcel in a tract of real estate may qualify for capital gain or loss treatment if the owner is a noncorporate investor, that is to say, the taxpayer is not a dealer in real estate or a C corporation. In other words, capital gain treatment on the sale of a subdivided lot or parcel in a tract of real estate is available only to a noncorporate investor. In brief, the corporate counterpart to our individual investor is likely in the business of buying and selling real estate; that is, in all likelihood the corporation is a dealer in real estate and any subdivided real estate in its hands is inventory, a noncapital asset according to the Internal Revenue Code. On the other hand, subdivided real estate in the hands of an investor is not viewed as inventory, which fact makes the property eligible for capital gain or loss treatment upon sale or exchange.

In particular, a lot or parcel in a tract of real estate held by a taxpayer who is a noncorporate investor qualifies for capital gain or loss treatment gain upon sale or exchange under the following conditions:

  1. The property is not, and has not been, held primarily and principally for sale to customers in the ordinary course of business. Moreover, at the time of sale or exchange of the property, the taxpayer must not have an inventory of real estate for sale to customers in the ordinary course of business. In short, the taxpayer cannot be a dealer in real estate.
  2. The property has been held by the taxpayer for at least five years. However, if the property is inherited or acquired by devise, there is no long-term holding requirement: capital assets acquired by such means are automatically assigned a long-term holding period.
  3. The taxpayer has not made substantial improvements to the property. There is an exception to this rule for expenditures that are necessary to make the property marketable. Improvements in this category–for example, expenditures for road installation, water, sewage, drainage, etc.–are not considered substantial improvements if the property is held for at least 10 years. The flip side: the taxpayer must not add the cost of these improvements to the basis of the property or take a deduction for the expenditures.
  4. If the property is one of the first five sold from the same tract of real estate, then any gain is a capital gain. But in the year the sixth lot (or parcel) is sold, the gain on the sixth lot and its successors will be taxed at ordinary income rates in an amount equal to 5% of the selling price; any remaining gain will be taxed at capital gains rates. Selling expenses for the sixth lot and its successors are first deducted from the ordinary income portion of the gain; any selling expenses that remain are then used to reduce the taxpayer’s capital gain.
  5. If the taxpayer waits five years after selling lots (or parcels) from a tract of real estate, the gain on the sale of up to five additional lots from the same tract will be taxed as a capital gain.

Example 1: In May 2008, Smith subdivides a tract of land he purchased in September 1997 into 10 lots and sells five lots for $90,000 each. If the adjusted basis for each lot sold is $60,000, then Smith has a long-term capital gain of $30,000 per lot ($90,000 selling price - $60,000 basis).

Example 2: In June 2009, Smith sells at a price of $100,000 per lot the remaining five lots in the tract of land he purchased in September 1997. In this transaction, Smith will realize a $40,000 gain on each lot sold ($100,000 selling price - $60,000 basis). But since Smith has sold more than five lots from this tract of real estate in a five-year period, he must treat a portion of the total gain for each lot as ordinary income and the remainder as long-term capital gain. Thus, 5% of the selling price of each lot is subtracted from the total gain of $40,000 to yield $5,000 in ordinary income ($100,000 x 5%) and $35,000 in long-term capital gain per lot.

Additional relevant articles on real estate capital gains are listed below:

Many happy returns, Roger

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