A stock goes ex-dividend on a $1 cash dividend, and its share price drops about $1 that morning. Nobody got richer, yet the dividend is taxable. To measure return, you have to separate income, paper gains and your own money coming back.
An investment pays you in two ways: income while you hold it, and a change in its value. The exam splits that into five components of return: interest, dividends, realized and unrealized gains, and return of capital. Label every dollar before you compute anything, because each one is taxed differently.
Interest. A bond's coupon is its fixed annual interest rate on par value, usually $1,000. A 6% coupon pays $60 a year, normally as two $30 semiannual payments. Corporate bond interest is fully taxable. Internal Revenue Code (IRC) Section 103(a) excludes interest on state and local (municipal) bonds from federal gross income. Treasury interest is exempt from state and local tax (31 U.S.C. 3124(a)). For most bonds, interest supplies most of the total return.
Common mistakes
- Subtracting a day from the record date: That was the T+2 rule. An ordinary dividend now goes ex on the record date, so a regular-way buyer must buy one business day earlier.
- Taxing return of capital now: A $1 return of capital on a $50 basis is not income. Basis falls to $49, and the tax shows up in the gain at sale.
- Flipping the premium-bond order: For a bond bought at $1,100, yield to call is the lowest yield, not the highest.
Bottom line
- Return comes from interest, dividends, realized and unrealized gains, and return of capital.
- Unrealized gains are not taxed, and return of capital lowers basis instead of counting as income.
- Qualified dividends require holding the stock more than 60 days in the 121-day window that starts 60 days before the ex-date; a gain is long-term only after more than one year.
- A stock dividend is generally not taxed and leaves total basis unchanged, but a cash election makes it taxable.
Exam shortcut
Check the trade type before you work out any dates. For an ordinary dividend, a regular-way buyer gets the dividend only by trading no later than the business day before the record date, and the words "cash trade" flip that answer. On any bond yield question, compare the price with $1,000 par first. Above par, yield to call is the lowest answer. Below par, nominal yield is the lowest.
The full lesson (about 3,973 words, 26 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C13
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