Dividend taxes are not difficult. You just need to know a few things that can potentially lower your tax bill by 10% or more. This article covers all requirements and more for qualified dividends as well as qualified dividend vs. ordinary dividend tax rates. Discussion in this article is relevant for taxable accounts only.

Dividends and Their Relevant Dates

First, what are dividends and their important dates? Dividends represent payments made by corporations to their shareholders. You also earn dividends from holding exchange traded funds (ETFs) and mutual funds. 

Whenever a company declares a dividend, there is a so-called record date. You must be on the company’s books as a shareholder as of the record date to get dividends.

Once the firm sets the record date, there is the ex-dividend date. Stock exchanges set the ex-dividend date one business day before the record date. Thus, if you buy a stock on the ex-dividend date or after, you will not receive the dividend.

Consider this example of Intel.  Intel announced a dividend on February 22, 2023 in this press-release.

The dividend is payable on June 1, 2023, to stockholders of record on May 7, 2023. Based on this, the relevant dividend dates are as follows:

• declaration date: Wednesday, February 22, 2023
• ex-dividend date: Friday, May 5, 2023
• record date: Sunday, May 7, 2023
• payable date: Thursday, June 1, 2023

What is Qualified Dividends Income?

Qualified dividends are dividends subject to the 0%, 15%, or 20% preferential tax rate. These rates are the same as for long-term capital gain. Your brokerage will show qualified dividends in box 1b of the Form 1099-DIV. 

Qualified dividend income must meet all of the following requirements:

1. The dividends must have been paid by a U.S. corporation or a qualified foreign corporation. 
2. The dividends are not of the type of distribution excluded by the regulation.
3. The holding period is satisfied.

If a dividend does not meet all of the above requirements, it is considered an ordinary dividend. Ordinary dividends are taxed at ordinary income tax rates and are reported in box 1a of 1099-DIV.

Qualified Dividends vs. Ordinary Dividends Tax Rates (2023)

How are dividends taxed? Here is a table that shows tax rates for qualified dividends income.

Table 1. Qualified Dividends Tax Rates and Brackets (2023)

Let’s compare them to the tax rates for ordinary dividends.

Table 2. Ordinary Dividends Tax Rates and Brackets (2023)

We see that the tax savings can be substantial. Here is an actual tax savings for single and married filing jointly for a $10,000 dividend income.

Table 3. Qualified Dividends vs. Ordinary Dividends Tax Rate Savings (2023)

For instance, suppose your status is married filing jointly. Your total taxable income is $80,000 of which $10,000 are dividends. The tax savings are $1,200 or 12%. That is $1,200 that stays in your pocket.

Qualified Dividends Requirements

Let’s expand on those 3 requirements for the qualified dividends from above.

1. Domestic or Qualified Foreign Corporation

While it is clear what a domestic US corporation is, the definition of a qualified foreign corporation deserves some attention. A qualified foreign corporation means a foreign entity satisfying any of the following:

1. The foreign corporation is incorporated in a U.S. possession.
2. The corporation’s dividends fall under a comprehensive income tax treaty.
3. Conditions (1) or (2) are not met, but the stock is traded on a national securities exchange.

National securities exchanges include all major stock and options exchanges (NYSE, Nasdaq, Amex). But, they exclude over-the-counter (OTC) exchanges.

For instance, a firm traded on Tokyo stock exchange is a qualified foreign corporation. This is so because the US has a special tax treaty with Japan. Refer to the IRS Publication 550 for a complete list of countries that have tax treatments with the US. 

2. Distributions Excluded from Qualified Dividend

IRS says certain distributions cannot be qualified dividends income by law. While the exclusion list is long, examples of excluded distributions are:

• Capital gain distributions.
• Dividends received from deposits with credit unions, mutual savings banks and cooperative banks. Such distributions are reported as interest income.
• Dividends received from tax-exempt organizations or farmer’s cooperative.
• Dividends paid by organizations from their employee stock ownership plans (ESOP).

There are also a few other narrow circumstances that render dividends unqualified. For a complete list, again refer to the IRS Publication 550.

3. Qualified Dividends Holding Period

Qualified dividend must also satisfy a certain holding period. In particular, you must hold a dividend stock for 61 days or more during the 121-day period. The 121-day period begins 60 days before the ex-dividend date. When counting days, exclude the day of acquisition and include the day of sale. 

Let’s break this down with an example. Consider a company XYZ.

Let’s look at the timeline.

We see that the 121-day period starts on May 13, which is 60 days before the ex-dividend date of July 12. Further, the 121-day period ends September 10. Because you bought XYZ’s stock on July 5, the holding period starts on July 6 (exclude the day of acquisition) and ends on August 8. This makes your holding period 34 days, which is under the required 61 days. Thus, you have no qualified dividend income. Your entire dividend income is reported in box 1a (ordinary dividends) on 1099-DIV form. 

Exception for Preferred Stock

If you own preferred stock, the holding period rules are a little different. You must hold the stock 91 days or more during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days. If the preferred dividends are due to periods totaling less than 367 days, the holding period for common stock (61 days or more during the 121-day period) applies.

Diminished Risk of Loss

IRS says that the day count for holding period must be for unhedged stock positions. This means that you should not own any covered calls options or puts for the dividend stock. In case you do, the risk of loss is diminished and you may not count those days.

Diminished risk of loss arises when any of the following happens:

1. You had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities.
2. You were grantor (writer) of an option to buy substantially identical stock or securities.
3. Your risk of loss is diminished by holding one or more other positions in substantially similar or related property.

Condition 1 deals with owning a put option on a dividend stock. It also covers the case when you initiate a short position on another stock that is similar to the one you hold. Condition 2 deals with the situation when you sell (write) call option on your stock position. This produces the so-called covered call scenario. Finally, condition 3 is the catch-all stipulation to cover other esoteric cases.

In all these instances, you reduced the risk of loss and you cannot count days when this happened. In essence, IRS wants investors to have skin in the game to get special tax treatment for dividends. 

Condition 1 is relatively straightforward to understand. If you own a put option on your dividend stock, you must exclude days you owned it from your holding period. Likewise, suppose you own 100 shares of iShares S&P500 ETF and go short 100 shares on Vanguard S&P500 ETF. You must not count days you hold short position in Vanguard ETF for your holding period test.

Unfortunately, the interpretation of condition 2 (covered calls) is somewhat complex. Here is what to remember for covered calls in conjunction with holding period test:

For instance, you own a stock that trades at $50. Further, you want to maintain your holding period day count. To do so, don’t sell a call option with a strike price at or below $50 or calls that expires in less than 30 days.

In principle, it is possible to sell calls at-the-money (strike price of $50 or 1 strike in-the-money). But, to be safe, I stay away from that. In this case, I would sell (write) only call options that expire 30 days or more with a strike price above $50. 

Fortunately, our brokers are required by law to do all record tracking on our behalf. But, they won’t alert you if your holding period is compromised due to faulty covered call strategy. So, it is important to keep these things in mind.

REITs and MPLs Distribution Taxes

Finally, there are real estate investment trusts (REITs) and master limited partnerships (MLPs). 

REITs typically own real estate, such as commercial buildings and apartment complexes. In this instance, REIT’s main source of income is rent. There are also so-called mortgage REITs. They lend money to others to buy real estate or own mortgage securities issued by other banks. 

REITs are organized as pass through entities. This means that they do not pay taxes as long as they distribute 90% or more of their income to shareholders.

Similarly, publicly traded master limited partnerships are also pass-through entities. At least 90% of MPL’s income must come from the exploration, production, or transportation of natural resources. 

If you plan on investing in REITs and MPLs, be aware that the tax rules are more complex than those for corporate dividends. Distributions from REITs and MLPs can be:

Type	Source of Funds	Taxation Type
Ordinary Income	Taxable Income	Ordinary Income
Capital Gain	Sales of Assets	Long-Term Capital Gain
Return of Capital	Cash flows in excess of taxable income	Tax-Deferred Capital Gain (short- or long-term)

Ordinary income distributions from REITs and MPLs are taxed at an ordinary income tax rates.

Conversely, return of capital distributions are not taxed at the time of their distribution. Instead, such distributions reduce your investment cost basis and are tax-deferred. You will pay capital gain (short-term or long-term depending on your holding period) tax later when you sell your investment. 

Capital gain distributions occur when a REIT or MLP sells assets and distributes proceeds to shareholders. Capital gain distributions are taxed as long-term capital gain.

In practice, 70%-80% of MLPs distributions are classified as return of capital. This is so because MLPs are unprofitable most of the time due to large depreciation expense at the early life cycle stages.

At the same time, the majority of REIT distributions are ordinary income and they are taxed as such. This is so because most REITs generate positive taxable income. So, REITs distributions can be at a tax disadvantage from investor’s point of view.

In case REIT’s distribution exceeds its taxable income for a given year, there will be two parts to it. First is the ordinary income distribution that is equal to the taxable income. The other portion is the return of capital, which is the amount that exceeds REIT’s taxable income.

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Ordinary income distributions from REITs and MLPs can qualify for 20% qualified business income exclusion. This is true for eligible taxpayers up until 2025. So, there is some relief there. 

Investors’ Takeaways

Investment brokers do all the record-keeping work for us behind the scenes. So, all amounts reported on 1099-DIV form will be correct no matter what. However, our job is to keep an eye on holding periods and other requirements if lower tax rates from qualified dividends are desired.