LOISELLE, GOODWIN & HINDS
CERTIFIED PUBLIC ACCOUNTANTS

Holding period rules for low-taxed capital gains and dividends

The often over-used expression about “what a difference a day makes” is right on the money when it comes to selling appreciated capital assets or dividend-paying stocks (whether or not they have appreciated in value). One less day of ownership can be the difference between having your gain or dividend income taxed at rates as high as 35%, instead of at the preferential 15% top tax rate that applies to long-term capital gain from most capital assets and to qualified dividend income (and at a 5% top rate for those who otherwise would pay 15% or 10% tax on the gain or dividend). The tax term involved is called the holding period, the minimum period of time you must hold a capital asset for gain to be favorably taxed long-term capital gain, or for otherwise qualifying dividend income to be eligible for the long-term capital gain tax rates.

Here's an introduction to some of the more common holding period rules. It will help keep you from making a tax mistake that you won't be able to undo once your trade is made. Keep in mind, however, that the tax payable on your gain or dividend income is only one of the factors to take into account in deciding when to sell a capital asset. For example, if you expect a stock's value to decline substantially before the long-term holding period is met, you may very well be better off by selling that stock immediately and paying tax at the higher rate for short-term gains.

General holding period rule. To yield “long term” capital gain, an asset must be held for more than one year, in other words, for at least a year and a day. The holding period begins on the day after you buy an asset, and ends on the day you sell it. For example, suppose you bought stock on June 4, 2003. Your holding period began on June 5, 2003 (the day after you bought). If you sell at a profit on or after June 5, 2004, your gain will be long-term capital gain. If you sold on June 4, 2004, your gain or loss is short-term, taxed at the same rate as ordinary income. Keep in mind that for publicly traded securities, the holding period begins on the day after the trading date you bought the securities, and ends on the trading date you sold them.

Dividends taxed at long-term capital gain rates. Qualified dividends that you receive from domestic corporations and “qualified foreign corporations” (many foreign corporations fall in this category) are taxed at the 15% and 5% rates applicable to long-term capital gains. To get qualified dividend income, you must hold the stock on which the dividend is paid for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (this is the first date following the declaration of a dividend on which a stock buyer won't receive the next dividend payment). As with the holding period for long-term capital gains, you include the day you sold the stock when counting the number of days you held it, but not the day you bought the stock.

For example, suppose you buy ABC stock on July 8, 2004. ABC pays a $500 cash dividend and the ex-dividend date is July 9, 2004. You sell the stock on Sept. 9, 2004. The 121-day period runs from May 10, 2004, through Sept. 7, 2004. You hold the stock for more than 60 days in this period (you hold it 61 days, from July 9, 2004, through Sept. 7, 2004, plus another two days through the sale on Sept. 9, 2004). Thus, the dividend is eligible for the favorable long-term capital gains rates.

For dividends paid on preferred stock which are attributable to a period or periods totaling more than 366 days, you must hold the stock for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date.

Special holding periods. There are a number of special holding periods that must be met for certain types of gains to be favorably taxed. Here are a few of them:

• If you inherit a capital asset, you automatically are treated as having held it for more than one year. Thus, for example, if you inherit a vacation home and sell it six months later at a gain, your gain, if any, is low-taxed long-term capital gain. (You will get a step-up in basis equal to the property's value at the death of the person who left it to you, so there may not be much gain in the ensuing six months.)
• A dual holding period applies if you have been granted an incentive stock option (ISO) by your employer and you exercise the option and buy stock. To qualify for full long-term capital gain treatment on the stock you buy, you must hold the stock for (1) at least one year after the shares were transferred to you, and (2) at least two years from the date that the ISO was granted.
• Up to one-half of the gain on the sale of qualified small business stock is tax free (and the balance is taxed at a special 28% capital gains rate) if the stock was originally issued after Aug. 10, '93 by a qualifying corporation, and the stock is held for more than five years. (The exclusion is 60% if the company operates within certain “empowerment zones.”)
• If you invest in commodity futures, gain on the sale of those futures qualifies as long-term capital gain as long as you held them for at least six months and a day before the sale.
• A capital gain dividend from a mutual fund automatically is treated as long-term capital gain, regardless of how long you held the mutual fund shares generating the dividend.

Adding on someone else's holding period. There are instances where your holding period includes someone else's. For example, if someone gives you stock, your holding period includes the donor's holding period. Similarly, if you acquire property from your spouse (or your ex-spouse, in the case of a divorce), your holding period includes your spouse's (or ex-spouse's) holding period.

Adding on another property's holding period. Where you defer gain on property by exchanging it for other like-kind property, the holding period of the new property includes the holding period for the old property. Thus, for example, if you swap an apartment building for an office building, your holding period for the office building includes the period of time you held the apartment building.

Where holding period doesn't matter. It doesn't matter how long you hold assets such as stocks or bonds owned by an IRA or a qualified retirement plan account. That's because all your withdrawals will be treated as ordinary income. And if the assets are held within a Roth IRA, your withdrawals will be 100% tax-free if they are qualified distributions (made after you've had a Roth IRA for five tax years and paid out after you are 59-1/2, or if you are disabled, or for certain first-time homebuyer expenses, or after your death).

Keep in mind that this discussion touches on the more common types of holding period rules. Please contact us and we'll be happy to explain how the rules apply to your personal situation, and help assure that you'll pay the lowest possible tax when you sell any capital asset.

(06/03/03)

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Last modified: July 15, 2004