There is a difference between capital gains and dividend income. Dividends are assets paid out of the profits of a corporation to the stockholders, whereas capital gains occur when an investment is sold for a higher price than the original purchase price. An investor does not have a capital gain until an investment is sold for a profit. The dividends an investor receives are not considered capital gains but rather income for that tax year.
Dividends are usually paid as cash, but they may also be in the form of property or stock. Dividends can be ordinary or qualified. All ordinary dividends are taxable and must be declared as income. Qualified dividends are taxed at a lower capital gains rate.
Capital gains are considered short-term if an asset is held less than one year. Short-term capital gains are taxed as ordinary income for the year. Assets held for more than a year are considered long-term capital gains upon sale. Tax is calculated only on the net capital gains for the year. Net capital gains are determined by subtracting capital losses from capital gains for the year. For most investors, the tax rate for capital gains will be less than 15%.
When a corporation returns capital to a shareholder, it is not considered a dividend and reduces the shareholder’s stock in the company. When a stock basis is reduced to zero through the return of capital, any non-dividend distribution is considered capital gains and will be taxed accordingly. An investor receiving large sums in dividends needs to pay estimated taxes to avoid a penalty.