Dividends are taxed at the same, most favorable, 0% and 15% rates that apply to long-term capital gain (for purposes of both the regular tax and the alternative minimum tax) — but only if the dividends are “qualified dividend income.” (Dividends that aren't qualified dividend income are taxed at the same up-to-35% rates that apply to ordinary income.)

Generally, qualified dividend income means dividends received during the tax year from:

domestic corporations, or

qualified foreign corporations (that is, with certain exceptions, U.S. possessions corporations, foreign corporations whose stock is traded on established U.S. securities markets, and foreign corporations eligible for income tax treaty benefits).

However, in order for you to treat a dividend as qualified dividend income, you must hold the underlying stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. If the dividend was declared on preferred stock and is attributable to a period of more than 366 days, you must hold the underlying stock for more than 90 days during the 180-day period beginning 90 days before the ex-dividend date.

Qualified dividend income does not include the following:

(1) any dividend on any share of stock to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property (for example, in connection with a short sale);

(2) any payment in lieu of dividends (for example, payments received by a person who lends stock in connection with a short sale);

(3) any dividend that you elect to treat as investment income for purposes of the rules governing the deduction of investment interest;

(4) any dividend from a tax-exempt charitable, religious, scientific, etc., organization, religious or apostolic organization, qualified employee trust, or farmers' cooperative;

(5) any deductible dividend paid by mutual savings banks, etc.;

(6) any deductible “applicable dividends” paid on “applicable employer securities” held by an employee stock ownership plan (ESOP).

Mutual fund dividends. The qualified dividend income rules discussed above apply to dividends on stock that you own, directly or through a brokerage account.

What about dividends from mutual funds? If you own shares of a mutual fund that holds dividend-paying stock, to the extent that the dividends received by the mutual fund are qualified dividend income, you are entitled to treat the dividends you receive from the mutual fund as qualified dividend income, taxable at the 0% or 15% maximum rates.

The mutual fund should notify you, by means of Form 1099-DIV, how much of your income from the mutual fund is eligible for qualified dividend income treatment.

Dividends received by other pass-thru entities. In addition to mutual funds, you may have interests in other types of “pass-thru” entities that receive qualified dividend income that's “passed through” to you — e.g., partnerships, S corporations, estates, trusts, real estate investment trusts (REITs).

By and large, you may treat your share of the qualified dividend income of these entities as qualified dividend income. As in the case of mutual funds, these entities should notify you, on the appropriate form, how much of your share of their income is eligible for qualified dividend income treatment.

Effect of capital losses on dividends. While qualified dividend income is taxed at the same rates as long-term capital gain, it isn't actually long-term capital gain. Therefore, you can't use capital losses that otherwise enter into the computation of your taxable “net capital gain” (the excess of net long-term capital gain over net short-term capital loss) to offset your qualified dividend income. As a result, generally, your qualified dividend income will be taxed in full at the 0% or 15% rates.

However, if your capital losses exceed your capital gains for the tax year, the excess, up to $3,000, can be used to offset other income. This offset can be used against qualified dividend income, but only after it has been used against taxable income other than qualified dividend income. This “ordering” rule is actually a benefit, because offsetting taxable income other than qualified dividend income, which is taxable at rates up to 35%, saves more tax than offsetting qualified dividend income, which is taxed at no more than 15%.

Planning. The taxation of dividends at the highly favorable 0% and 15% rates otherwise applicable only to long-term capital gains may make investment in dividend-paying stock significantly more advantageous than other types of investments that produce income taxed at the regular up-to-35% rates (for example, rental real estate, or any type of investment that produces taxable interest).