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 taxes:

• 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.

Capital Gains

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 shares.  And every time you send them and optional investment, you have purchased more shares.

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 transaction-type:

• Dividend 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.

• Dividend 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.

• Commission (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.

• Fees (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).

• Discounted 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 final advice.