3 Dividend Tax Traps You Must Avoid

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One of the best things about dividend stocks is that the income they generate typically gets taxed at a preferential rate. For some lower-income taxpayers, dividends become effectively tax-free. However, there are some things you need to know about this dividend tax break that will help you make sure you qualify and don't do anything to endanger it. In particular, below you'll find three ways in which dividend income might not qualify for low-tax treatment so you can decide for yourself what to do.

1. Some investments don't pay qualified dividends.Even if something is called a dividend doesn't mean that it necessarily qualifies for the lower tax rates. For instance, the IRS points to dividends from tax-exempt corporations or cooperatives, credit unions and similar financial institutions, and dividends on stock held by an employee stock ownership plan as never being qualified.

In addition, most dividends from real-estate investment trusts are treated as ordinary income not qualifying for the lower dividend rate. A REIT can pass through qualified dividends it receives from a qualifying corporation in which it has itself invested. Master limited partnerships are another example, in part because the money that MLPs pays to its investors are technically distributions of partnership income rather than dividends.

2. Only certain foreign corporations can pay qualified dividends.In order to pay qualified dividends, a company must be organized either as a U.S. corporation or be considered a qualified foreign corporation. Foreign corporations must either be incorporated in a U.S. possession, be eligible for the benefits of a comprehensive income tax treaty with the U.S. as approved by the Treasury Department, or have their shares listed and readily tradable on an established U.S. securities market. The New York Stock Exchange and Nasdaq Stock Market are the two biggest acceptable markets, but the full list includes several regional markets as well.

3. You have to hold the stock for a set holding period in order for dividends to be qualified.Even if the company meets all the requirements for paying a qualified dividend, investors have to follow their own rules in order to get that preferential treatment on their own tax returns. In particular, the investor must hold onto shares of the company for a set time period surrounding the dividend payment. In the words of the IRS rule, you must have held the stock for more than 60 days out of the 121-day period that begins 60 days before the ex-dividend date.

That IRS rule is a mouthful, but it's helpful to understand the reason for the rule. Lawmakers didn't want investors to buy a stock immediately before it paid a dividend, hold it just long enough to get the dividend, and then sell it. By doing so, investors would potentially be able to get tax-preferred dividend income balanced out by a short-term capital loss they could use to offset tax at higher ordinary income rates.

Therefore, the IRS requires you to own a stock for a minimum of two months in order to get preferential tax treatment on the dividends. It doesn't matter if you own the stock for two months before the ex-dividend date and then sell it right afterwards, or you buy the stock right before it goes ex-dividend and then hold it for two months -- either qualifies, as does any point in between. By eliminating the extremely short-term trader, the IRS ensures that you be willing to accept at least some risk in exchange for positive treatment.

Dividend investing can be quite lucrative, and the tax breaks that you can get from it are icing on the cake. By keeping these three potential pitfalls in mind, you can make sure that you'll capture as much tax benefit as possible from your dividends and not get a nasty surprise at tax time.

The article 3 Dividend Tax Traps You Must Avoid originally appeared on Fool.com.

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