Are Dividends Taxed as Ordinary Income?

Dividends are payments that a corporation distributes to the shareholders, often quarterly but at least annually. Not all public companies pay dividends, but some pay them reliably. Some examples include Exxon Mobil, Verizon, Enbridge, VF Corp, Unilever, and 3M. In addition, some companies have a long history of paying dividends, including DuPont, Edison, General Mills, Eli Lilly, and Stanley Black & Decker. Dividend-oriented investors may rely on these payments, and some companies have encountered an investor backlash when they have reduced or dropped their dividends (often due to financial hardship).

How are dividends taxed?

Some dividends are taxed as ordinary income, while others qualify for the same rate as long-term capital gains, which is more favorable. Whether you pay the regular income (higher) rate or the lower capital gains percentage depends on several things.

First, the company issuing the dividend can't be expressly excluded from qualifying. Most U.S. companies qualify, and some foreign firms. For foreign corporations, the company can qualify by meeting one of these three conditions:

1. It is incorporated in a U.S. possession. U.S. territories like Guam and Puerto Rico are familiar possessions, but some lesser-known examples are Navassa Island, Jarvis Island, and Baker & Howland Islands.
2. The stock is widely traded on a U.S. exchange.
3. The corporation is in a country with a comprehensive income tax treaty with the U.S. Examples include Canada, China, Sri Lanka, Sweden, Switzerland, Iceland, Israel, Italy, and Japan.  

Second, the taxpayer must meet the holding requirements. For example, suppose you have held the dividend-paying security for at least 60 days before the ex-dividend date (the business day before the dividend is announced). In that case, the dividend income is considered qualified and will be taxed at the lower long-term capital gains rate. Also, if the stock type is preferred rather than common, the holding period increases to 90 of the 181 days before the ex-dividend date. This provision is in place because preferred stock lacks voting rights but pays dividends before common stock does. 

If the investor hedges the stock during the holding period, any dividends are automatically disqualified. Hedging means the investor used strategies such as puts, calls, or short sales.

Is a dividend the same as a capital gain?

Capital gains are only realized when the investor sells the asset. For example, a stock may enjoy a tremendous increase in value, but if the investor doesn’t sell it, they do not owe taxes on that appreciation. In contrast, dividend income is taxable in the year the investor receives it.

What dividends are excluded from qualification?

Employee stock options are typically not eligible for the lower tax rate, and in most cases, distributions from Real Estate Investment Trusts (REITs) and master limited partnerships are excluded. However, the Tax Cuts and Jobs Act allowed a deduction of 20 percent of pass-through business income, including income from REIT distributions. This special deduction expires at the end of 2026 but currently can aid in reducing the effective tax rate.

Also, suppose a REIT has activities that generate income but are outside the scope of real estate (which is allowed up to 75 percent). In that case, the income attributed to those activities is potentially eligible for the lower, qualified rate.