Are Preferred Stock Dividends Qualified?

Preferred stock is an equity investment that appeals to those seeking regular income from fixed dividend payments. How these dividends are taxed is important, as the Internal Revenue Service (IRS) allows “qualified dividends” to be taxed at more favorable long-term capital gains rates instead of higher ordinary income rates. Understanding the rules for whether preferred stock dividends meet this standard is a key part of tax planning.

General Requirements for a Qualified Dividend

For a dividend to receive preferential tax treatment, the payment must come from a U.S. corporation or a qualified foreign corporation. A foreign corporation qualifies if it is incorporated in a U.S. possession, is eligible for benefits under a U.S. tax treaty, or its stock is readily tradable on an established U.S. securities market.

Certain types of payments are also excluded from being treated as qualified dividends. These include:

• Distributions from credit unions, mutual savings banks, and tax-exempt organizations
• Payments from real estate investment trusts (REITs) and master limited partnerships (MLPs)
• Payments made in lieu of dividends, which can occur in situations involving short sales or certain derivative contracts

A holding period requirement also applies, but the rule for preferred stock has distinct and more stringent characteristics.

The Specific Holding Period for Preferred Stock

The holding period for preferred stock is more stringent than for common stock. To be eligible for lower tax rates, an investor must hold the preferred stock for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date. The ex-dividend date is the first day a new buyer is not entitled to the upcoming dividend. For comparison, common stock only requires being held for more than 60 days during a 121-day period.

The IRS has rules for what it means to have “held” the stock that can pause the holding period clock. Any day where the investor’s risk of loss is diminished does not count toward the 90-day requirement. If an investor has an option to sell, is under a contractual obligation to sell, or has a short sale of substantially identical stock, the holding period is suspended. These rules prevent investors from briefly holding a stock just to capture a tax-advantaged dividend without bearing the full risk of ownership.

For example, if an investor buys preferred stock 30 days before the ex-dividend date and simultaneously buys a protective put option (an option to sell at a set price), the days the put option is held do not count toward the 90-day holding period. The clock only resumes once the put option is sold or expires. Therefore, the investor must hold the stock for a much longer calendar duration to accumulate the required 91 unhedged days. Failing to meet this specific holding period reverts the dividend’s tax treatment to the higher ordinary income rates.

How Dividends are Reported for Tax Purposes

Investors receive Form 1099-DIV, Dividends and Distributions, from their brokerage firm or the paying corporation. This form details the tax status of their dividends. Box 1a shows the total ordinary dividends paid, which is the gross distribution before any determination of its qualified status.

Box 1b reports the portion of dividends the payer identifies as potentially qualified. While the payer makes this initial determination, it does not certify that the investor has met the personal holding period requirement. That responsibility rests solely with the taxpayer.

An investor must personally verify they met the holding period for the dividends reported in Box 1b. If the holding period was met, the amount from Box 1b is reported on Form 1040 to be taxed at the long-term capital gains rate. If the taxpayer did not meet the holding period, they must treat those dividends as ordinary income.