Tax Treatment of DRIPs
Until the release of DRIP
Wizard, there were only two
reasons that an individual investor should not invest in DRIPs.
First, there was the difficulty in calculating the value and yield of your
investments. Second, the file keeping required to properly treat the
tax consequences of DRIPs was too much to do by hand.
But DRIP Wizard does all of the work. When you
run the program, simply press the Tax
Summary Button, enter the Start Date and End Date, then Press
Generate. A report will be shown on the screen (also printable)
which will breakdown all dividend income, capital gains, and possible
deductions from all of your DRIP investments.
For the most part, there are only two pieces of
information that each DRIP supplies the investor with to help them file
1099-DIV. At the end of the year each
DRIP will send you and the IRS a copy of the 1099-DIV form. This
form reports all Dividends and Distributions paid to you over the past
year. Dividends that are reinvested
are considered a paid Dividend at the time they are reinvested.
In addition, other transaction types can qualify as paid
dividends. See below.
Account Statements. Each time a
transaction occurs (dividend reinvestment, optional cash payment,
stock split, etc.), the DRIP will provide you with an updated Account
Statement for the year. ***Important*** for each DRIP,
keep the last Account Statement for the year, as this is the only
hardcopy that you will receive showing your transactions.
Using DRIP Wizard, you will take information from the
Account Statement and put it into the program. This is very easy to
do. And once done, tax reports can be generated with one click.
The most important (and often overlooked) tax consequence
of DRIPs is Capital Gains. Capital Gains are often overlooked by
DRIP Investors because they are more concerned about building their
investments than they are about selling them. This is a wise way to
invest. But eventually, everyone will sell their shares. And
when they do, the IRS will expect that they calculate their Capital
Gains for the Sale.
The task of determining Capital Gains can be almost
impossible. This is a consequence of one of the biggest benefits of
DRIPs--that is, you are frequently purchasing shares. Every time a
dividend is paid and reinvested, you just purchased another small chunk of
And every time you send them and optional investment, you have purchased
When figuring out Capital Gains, you must consider these
questions . . . If I sell part of my holdings, which shares did I sell and
which did I keep? When you sell more shares later, which purchases
were already sold and which ones remain? What is my average purchase
price (as it is spread across so many transactions)? How will
stock-splits effect the calculations? Are there any commissions or
fees that will increase my cost-basis (lower my Capital Gains)? DRIP Wizard automatically answers all of these questions--and leaves the
information to clearly show all the results.
Nevertheless, here is how Capital Gains are calculated:
Capital Gains = #SharesSold * (Sell Price per Share - Cost
Basis per Share)
where Cost Basis per Share = Weighted Average Purchase Price per
Share + Commission Paid per Share for Purchasing Shares + Commission Paid
per Share for Selling Shares
To determine which shares are being sold, we look to the
tax code. Tax code states that "if you buy and sell
securities at different times in varying quantities and you cannot
definitely identify the securities you sell, then figure the basis of
those sold under the first-in-first-out method--that is, the first
securities you acquired are the first sold." Currently, the
IRS translates DRIP purchases as not "definitely identify"-able,
so the FIFO method should be used. If they are definitely
identifiable, then you can take advantage of a DRIP Wizard feature that
will automatically minimize or maximize your capital gains.
Tax Description by Transaction Type
Even when not selling shares, there will be some extra
activity to report when taxes are done. Here is a description by
Collected: Dividends, whether
reinvested or not, are considered a form of income. The amount
should be included on the "Dividends" line of Form 1040 or
1040A. It should also be reported on Schedule B of Form 1040 or
Schedule 1 of Form 1040A. Total dividends will be included on
the 1099-DIV form sent to you and to the IRS from each DRIP company.
Reinvestment: The amount of the
dividend is considered dividend income, even though you don't directly
see the income until the shares are sold. As with normal
dividends, the amount is included on 1099-DIV forms.
(aka Brokerage Fees): If paid
by the DRIP company (which is common) . . . it is considered dividend
income and will be included on the 1099-DIV form. Whether paid
by you or the company . . . a commission increases the cost basis of
the shares being purchased or sold. This means that a commission
will decrease your capital gains when you sell the shares.
(aka Service Charges): If paid by
the DRIP company . . . the amount must be reported as dividend income
and will be included on the 1099-DIV form. Whether paid by you
or the company . . . if you itemize your deductions, you can deduct
from your income any fees as an investment expense (1040 Schedule A).
Purchase: The amount of the
discount is to be reported as dividend income and will be included on
the 1099-DIV form. The cost basis for the shares will be the
full price of the shares.
Ultimately, you are advised to go to your tax advisor for