With the new tax law, most brokerages have been a bit slower than usual in getting the final 1099-DIV out to account holders, due to the rule changes affecting pass-through investments, to include REITs and Master Limited Partnerships and mutual funds holding these. But now most if not all brokerages have distributed their 2018 1099-DIVs, so I thought it might be worth the time to help those with questions understand what the new 1099-DIVs contain and the tax character of these distributions. The easiest way to tackle this is to step through the 1099-DIV boxes and then give an example of how these values are carried over to the tax return. But first, what are the types of income that are taxed at different rates?
Ordinary income. This is a combination of income received from multiple sources that collectively is taxed at tax-table rates. The typical sources are wages, corporate bond or CD interest, Traditional IRA (TIRA) withdrawals, pensions, interest received on a sales contract, dividends from Business Development Companies ((BDCs)), the taxable part of Social Security and net short term capital gains. On the tax return, all deductions are subtracted first from the household’s ordinary income and what is left is subject to tax at tax-table rates. Here’s an example for a couple; he is retired and collecting Social Security and she is self-employed.
For this example, no other forms of income that are taxed at differ tax rates are included, such as long term capital gains and qualified dividends (LTCG + QD). If they existed in this case, they would 'stack' on top of the taxable ordinary income of $58,300. All capital gains plus qualified dividends between $58,301 and $77,200, for 2018, would be taxed at 0%, while any above $77,200 will be taxed at 15% up until there is enough LTCG + QD stacked on the taxable ordinary income to reach $479,000 at which point LTCG + QD are taxed at 20%. (there would also be a Net Investment Income Tax of 3.8%, but that's another topic)
Net capital gains or loss. This is a net of all combined capital gains and capital losses, with net long term and net short term, if any, calculated separately and then netted out together. Capital gains can be reported on the 1099-DIV, Schedule K-1 and/or the 1099-B, with all sources of capital gains and losses carried over onto Schedule D and from this, the net carried over to Schedule 1 line 13. Here is an example of an individual who engages in active stock trading for the year, where Long Term means the investment was held longer than a year and Short Term means it was held less than 1 year:
Note that if there is a net of long or short term capital loss, up to $3,000 of this loss will be used as negative income on line 13 of Schedule 1. Any remaining unused capital loss will retain its character (long or short term) and be carried forward to the next year.
Qualified Dividends. These are dividends paid by a company from their earnings that have already been subject to taxation. In actuality, these are “Qualifiable” dividends, as to be ‘qualified’, the recipient of the dividends must also hold the common stocks that pay them at least 61 days over the 121 day period beginning 60 days before the Ex-Dividend date. For preferred stock, this is increased to a minimum required holding period of at least 91 days for the 181 day period beginning 90 days before the Ex-Dividend date. During this period the shares of stock paying the dividend may not be hedged or borrowed.
Once net capital gains have been determined and the total of qualified dividends is known, these two values can be combined in calculating tax, as they are both taxed EXACTLY the same.
The 1099-DIV has 15 boxes that may have values in them that must be carried over onto the taxpayer’s form 1040. Of these, there are 10 or so boxes that may have entries of importance to more than a minority of taxpayers. These are as follows:
Box 1a: Total Ordinary Dividends. These are all dividends from corporations or mutual funds (open end, closed end or Exchange Traded) holding corporate shares, and will include dividends subject to tax treatment as ordinary income and qualified dividends taxed at more favorable tax rates. Note that mutual funds that hold only bonds are included here even though technically what they distribute is interest paid on bonds, although it may also include capital gains from the sale of bonds.
Box 1b: Qualified Dividends. These are dividends paid from after-tax company earnings.
Subtracting 1b from 1a will give the dividends that will be taxed as ordinary income. This will generally include REIT, BDC and ETN dividends as well as short term capital gains distributed from mutual funds.
Box 2a: All capital gains (except for short term capital gains from mutual funds). This will include long term capital gains that will be combined on Schedule D with capital gains and losses from the sale of investment assets or received from a partnership, to determine the net long term capital gains or losses to be carried over into line 13 of Schedule 1
Box 2b: Unrecaptured Section 1250 gains. This is the part of 2a that represents the ‘recapture’ of depreciation. Here is a simple example of a rental home bought and held for several year and then sold:
Sec. 1250 capital gain is probably the least understood of all taxable gains, although it is really easy to understand. Unrecaptured Sec. 1250 is treated both as a capital gain and as ordinary income. As a capital gain it offsets capital loss, although ‘regular’ capital gains are used up first against capital losses. So in the above example, the $20 of LTCG is ‘used up’ against the -$25 of capital loss incurred elsewhere, leavings -$5 of capital loss which is then subtracted from the remaining $30 of Unrecaptured Sec. 1250 leaving $25 of Sec. 1250, which is then treated as ordinary income but is taxed up to a maximum tax rate of 25%. This means that for a couple married filing jointly, the tax ceiling of 25% would become a 'benefit' to them until their taxable income goes in to the 32% rate of $400,000.
Box 2c: Section 1202 Gain. This is a rare form of capital gain generally limited to private ownership of originally issued common stock of a Qualified Small Business organized as a C-Corporation that is held at least 5 years before being sold. 50% to 100% of the gain is excluded from taxation depending on the year the stock was originally purchased.
Box 2d: Collectible Gains. These are also rare, but can be realized from capital gains distributed from precious metal or commodity ETFs organized as grantor trusts or from the auction sale of a piece of art or antique automobile held for more than one year and then sold for more than the collectible’s basis. These are also treated as capital gains for purposes of being offset by other capital losses. But if not offset, are then taxed as ordinary income up to a maximum rate of 28%.
Box 3: Non-Dividend Distributions. These are distribution in excess of the company’s earnings (including any retained earnings from previous years) and in excess of any realized capital gains. Often called ‘Return of Capital’, this is not taxed to the shareholder, but it must reduce the shareholder’s basis of the company. If the basis reaches zero, any addition amounts in box 3 must be declared on Schedule D as Long Term Capital Gain.
Box 4: Federal Income Tax withheld. Sometimes called ‘Backup Withholdings’, this is unusual except for shareholders, including foreign shareholders, who do not provide a valid Social Security Number or a Taxpayer ID number.
Box 5: Section 199A Dividends. These are new for 2018 under the Tax Cut and Jobs Act (TCJA), and represent the pass-through business income from REITs that is usually equal to box 1a minus anything in box 1b. Combining all REIT box 5 amounts is the total amount, plus or minus any positive or negative distributions from Master Limited Partnerships, that is eligible for the 20% 199A deduction. The amount is used in the worksheet for calculating the Qualified Business Income Deductions taken on line 9 of the form 1040.
Box 6: Investment Expenses. An amount here is rare and generally applies to private mutual funds or private BDCs incurring external expenses paid from the value of the fund. But under the TCJA this amount, at least for the individual filer, is no longer deductible as a miscellaneous itemized expense subject to the 2% of AGI limit.
Box 7: Foreign Taxes Paid. Holding foreign stock, either directly or through a mutual fund, may generate a foreign tax on foreign stock. This may be deducted as an itemized deduction or taken as a foreign tax credit on line 48 of Schedule 3 if it is less than $600 for married filing jointly, or less than $300 for single filers. If greater than this, then a form 1116 must be completed.
Box 9 and 10. Company liquidation proceeds. Very rare. Used to adjust the basis of the holding.
Box 11. Tax Exempt Interest. Usually paid from mutual funds and considered a dividend even though it is almost always interest from municipal bonds. Interest from General Obligation Municipal Bonds are not taxable but may be included in Modified Adjusted Gross Income for various calculations so must be entered on form 1040 line 2a
Box 12. Private Activity Bond Interest paid as a dividend usually from a mutual fund although it could come from individually held bonds. This is part of Box 11 that represents interest from non-government municipal bonds, sometimes referred to as ‘income bonds’. Like government issued general obligation muni bonds, the interest paid (mutual fund dividends) is not includable as income but this interest is used in the calculation of Alternative Minimum Tax.
Boxes 13-15. This is for state tax only when dividend amounts have been withheld for state tax.
Interestingly, the 1099-DIV does not provide the total distribution that was received from the stock or fund shares. However, this can be calculated by adding together any values shown in boxes 1a + 2a + 3 + 4 + 7 + 11.The “January Dividend”
If you hold individual REITs and/or mutual funds that pay a dividend in early January, you might have noticed that the total dividends paid for a year may not equal the amount shown on the form 1099-DIV. The reason for this is unique to these securities, for whom the IRS has determined that any dividend declared in the 4 th quarter of the calendar year with its dividend date of record occurring in the 4 th quarter but the dividend actually paid in January of the next year, the dividend is reported as having been received in the 4th quarter even though it was not actually received until January of the next year. Lexington Realty Trust (LXP) and National Health Investors (NHI) are a couple of examples of this.
What to do with this information
Here is a breakdown in Excel of the dividends I’ve received on some of the REITs I hold
By building this Excel table, you can now do a couple of important functions that would be difficult to do otherwise:
1. Predict what your 199A income will be for next year. Although there will certainly be some variability in REIT and fund distributions types from year to year, I've found REITs tend to be fairly consistent. So in this case with these 6 REITS, about 83% of the annual REIT dividends were 199A dividends (my actual universe of 25 REITs was just over 75% of total distribution as 199A dividends). So if you can predict your REIT total distributions for 2019, you can make a projection on how much of it will be 199A dividends and from this, 20% will be the actual deduction.
2. Similarly, you can predict the % of the 2019 distributions that will be QD + LTCG and ROC, allowing you to more accurately project the 2019 Fed income tax and thus to calculate quarterly estimated tax payments
Disclosure: I am/we are long NHI, LXP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.