Taxation of Preferred Stock

With preferred stocks, you'll likely earn taxable dividend income each year you own the shares.
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Preferred stocks are capital assets and are subject to the same taxation as common stocks when they're sold at a gain or loss. Your preferred shares have additional tax implications, however, as they generally provide you with fixed dividend payments when the corporation is profitable. Dividends, as well as the profit you earn when selling preferred shares, are equally taxable, but this doesn't necessarily mean you'll owe tax on both types of income.

At Time of Stock Purchase

On the day you purchase shares of preferred stock, there's no taxation, but your basis in the stock is established at this time. Your tax basis is the total cost to acquire the preferred shares, which is usually the fair market value of the stock plus associated costs, such as the commission you're charged to make the trade. Tax basis is important because it reflects the maximum amount you can receive tax free if you ever sell the shares.

Gain or Loss From Sale

When you sell the shares, you'll calculate the gain or loss as the selling price -- which is reduced by the sale-related commissions and fees you pay -- minus your tax basis. Regardless of whether you end up with a gain or loss, the sale must be reported on your tax return with the specific details entered on Form 8949 and Schedule D. How a sale of preferred stock impacts your return depends on your holding period and the amount of capital gains and losses you have from other transactions.

Holding Period and Reporting

Your holding period, or the amount of time you owned the preferred stocks before selling them, is either short term or long term. A long-term holding period simply means you acquired the shares more than one year ago, whereas a short-term holding period is one year or less of ownership as of the date of sale. Long-term capital gains are potentially taxed at lower rates than you pay on most of your other income. Those higher rates are referred to as “ordinary income tax rates” and apply to short-term preferred stock gains. Since you combine all capital gains and losses together before calculating the tax, all losses are treated the same. Losses can offset your current and future capital gains. And if you have more losses than you need, up to $3,000 is deductible from income on your return that's subject to ordinary income tax rates.

Taxation of Preferred Dividends

Separate from the taxation on sales of preferred stock, the dividend payments you receive during your holding period must be reported on your tax return each year. The general rule is that dividends are taxed at ordinary income rates. If the dividends are qualified, meaning the preferred shares satisfy a number of eligibility requirements, they're taxed at those lower long-term capital gains rates. Most people will pay tax on qualified dividends at the rate of 10 percent. But if your taxable income for the year isn't taxed beyond the 15 percent tax bracket, your qualified dividend income is tax free, while very high income earners are taxed at the maximum rate of 15 percent. In most cases, the 1099-DIV you receive will tell you whether the dividend payments are qualified.

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