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For tax purposes, are preferred stocks treated more line bonds or common stocks? Specifically, do preferred stocks require special handling for premiums and discounts like bonds would.

Thanks in advance!
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mectetcinc,

You wrote, For tax purposes, are preferred stocks treated more line bonds or common stocks? Specifically, do preferred stocks require special handling for premiums and discounts like bonds would.

Yes.

… Depends on the preferred and the corporate structure issuing it. I could explain why … but you didn't ask that question.

FWIW, you can usually find the tax treatment for a specific issue on quantumonline.com.

- Joel
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Expanding just slightly on Joel's response...

There are many different types of preferred stocks since "preferred" in this context only means "not common". The tax treatment of their distributions can vary dramatically and there is no easy way to know what that treatment will be. You must look at the offering documents for the answer.

Ira
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Preferred Stock (PS) are a class of stock (equity) with 'preferred' characteristics, such as convertibility, first claim on dividend payment and a higher priority to company assets in the case of bankruptcy. Unlike bonds, there is generally no maturity date...although there may be a mandatory conversion date that is rare in my experience.

PS, like bonds, tend to be thinly traded, so to help create a market, they are usually issued with a fixed dividend, (like bond coupon rate), with a guarantee of paying this dividend for a fixed period, usually 5 years, before the PS may be redeemed (not 'called' as a bond may be) at usually its issue price that is most commonly $25/sh. Because of this, the PS will usually have a limited trading range and as it approaches its 5th anniversary, the price will usually hover around its issue price, unless the company is getting financially distressed, which will greatly reduce the likelihood of redemption and usually shows up as a reduced share price.

Because most PS have no maturity date and may be perpetual, they are not spoken of as having a premium or discount. For most, redemption is totally at the discretion of the issuer. In my experience, the stronger the issuer and with stable or declining interest rates, the more likely the PS will be redeemed on or close to its 5th anniversary. The weaker the company, the less likely this is.

And for tax purposes, PS dividends are just that, dividends and not interest, meaning they may be qualified dividends if issued by a C-Corporation or LLC that files as a corporation. (note: Trust Preferreds (from small banks) and Exchange Traded Debt (baby bonds) look like PS but are classified as Debt and are not company equity)

BruceM
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irasmilo,

You wrote, There are many different types of preferred stocks since "preferred" in this context only means "not common". The tax treatment of their distributions can vary dramatically and there is no easy way to know what that treatment will be. You must look at the offering documents for the answer.

Expanding on your answer:

The tax treatment of preferred stock of an issuer depends largely on the guarantees provided in the prospectus and the tax status of the issuer. And when I say issuer, I mean the actual issuer.

Some preferred stocks are issued by investment trusts. These can be REITs (Real Estate Investment Trusts) or some other type of Investment Trust constructed by a bank, brokerage house, insurance company or investment management firm. (I'm sure I've seen a couple issued by non-financial businesses as well.) What confuses some people is that it's the tax status of that Trust that influences the tax status of dividends paid on the preferred - not the tax status of the company that constructed the trust. And since most such trusts are investment trusts, they are constructed as pass-through entities for corporate purposes. Therefore the tax characteristics of their dividends are inherited from the income the Trust used to make the payments. This means in theory such dividends can be anything from interest to qualified dividends … but what they will actually be treated as is usually spelled out in the prospectus. (I have seen a couple of issues where the issuer had to publish a schedule each year.)

On the other hand, most for-profit corporations pay taxes and then pay dividends out of net proceeds. That is to say, such dividends are a distribution of retained equity. Such distributions are (usually) taxed as qualified dividends - at least as long as (timely payment of) the dividend is not guaranteed. If the dividend is guaranteed, the issue is effectively a bond or promissory note (for tax purposes) that is junior to other debt obligations; but its dividends would likely be treated as interest payments or at least would not be considered qualified dividends.

QuantumOnline.com's listings do try to show if a preferred's dividend payment is qualified or not; but they only have a Yes/No answer. It's rare, but occasionally the correct answer is not Yes or No, but rather some mixture. To be certain you may have to actually review the issue's prospectus. In fact, I would always recommend someone at least skim through an issue's prospectus because often there are complex conditions involved that make them anything but simple investments.

- Joel
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Thank you all for your kind replies. I found them very informative.

In my experience with preferred stocks, most are issued at $25/share. Depending on market conditions, the interest rate environment, corporate financial condition, etc., they can trade at a premium or discount to the issue price. If you buy a bond on the open market at a discount to its $1000 par value issue price (for say $900), the bond will ultimately mature at $1000 or could be called for $1000. That $100 "appreciation" is treated as interest not capital gain in bond tax accounting. My question would be do those bond tax rules (i.e. accrued market discount or amortization of bond premium etc.) apply to other income instruments like a preferred stock.
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My question would be do those bond tax rules (i.e. accrued market discount or amortization of bond premium etc.) apply to other income instruments like a preferred stock.

The answer is - it depends.

In general, when you sell a preferred stock for more than you purchased it for, or it's redeemed for more than you paid for it, the gain treated as a capital gain, not as interest. Selling/redeeming for less would generally be a capital loss.

That said, there are so many different capital structures for preferred stocks that you need to understand the tax treatment for each one you own, as it may be different. For instance, there are some preferred stocks that are subject to OID (Original Issue Discount), which could have an impact on how some/all of the gain/loss is treated.

AJ
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mectecinc,

You wrote, If you buy a bond on the open market at a discount to its $1000 par value issue price (for say $900), the bond will ultimately mature at $1000 or could be called for $1000. That $100 "appreciation" is treated as interest not capital gain in bond tax accounting.

I don't believe this is generally true. Certainly not for a taxable bond with a market discount in a taxable account. I do know you can also amortize market bond premiums to reduce your effective income, but I don't think this generally applies to discounts.

Of course I don't think I've ever held any individual bonds outside of my TIRA or 401(k), so I've never had to deal with the tax treatment myself. Other regulars on this board might correct me.

I have held trust preferred stocks that paid interest in my taxable accounts. (The trusts held bonds and distributed interest payments to the preferred shareholders.) Those shares were all purchased at a discount and eventually called at par. The discount was treated as a capital gain. I'm not sure my situation differs materially from the one in your quote above.

- Joel
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mectecinc wrote: If you buy a bond on the open market at a discount to its $1000 par value issue price (for say $900), the bond will ultimately mature at $1000 or could be called for $1000. That $100 "appreciation" is treated as interest not capital gain in bond tax accounting.

joelcorley answered: I don't believe this is generally true. Certainly not for a taxable bond with a market discount in a taxable account. I do know you can also amortize market bond premiums to reduce your effective income, but I don't think this generally applies to discounts.

Actually, mectecinc is correct. From IRS Pub 550 https://www.irs.gov/pub/irs-pdf/p550.pdf

Market Discount Bonds

A market discount bond is any bond having market discount except:
Short-term obligations (those with fixed maturity dates of up to 1 year from the date of issue),
Tax-exempt obligations you bought before May 1, 1993,
U.S. savings bonds,
and Certain installment obligations.

Market discount arises when the value of a debt obligation decreases after its issue date. Generally, this is due to an increase in interest rates. If you buy a bond on the secondary market, it may have market discount. When you buy a market discount bond, you can choose to accrue the market discount over the period you own the bond and include it in your income currently as interest income. If you do not make this choice, the following rules generally apply.

You must treat any gain when you dispose of the bond as ordinary interest income, up to the amount of the accrued market discount. See Discounted Debt Instruments, later.
(my bolding)

You can go ahead and read more details in the cited publication.

I have held trust preferred stocks that paid interest in my taxable accounts. (The trusts held bonds and distributed interest payments to the preferred shareholders.) Those shares were all purchased at a discount and eventually called at par. The discount was treated as a capital gain. I'm not sure my situation differs materially from the one in your quote above.

It does differ, because you bought a trust preferred, not an actual bond. There is also generally a difference in the treatment of accrued interest between bonds and preferred stocks (including trust preferreds), since preferred stocks are expected to 'trade flat' while bond trades generally include an adjustment for accrued interest.

From a tax perspective, this may make preferreds and other exchange traded debt preferable to bonds. But from a capital structure perspective, senior bonds are generally superior to preferreds - even trust preferreds, since the bonds that trust preferreds are set up are generally junior bonds, and even if the underlying bonds for a trust preferred are senior bonds, the obligation is owed to the trust, not to the holder of the trust preferred. Therefore, when buying trust preferreds, you need to understand what obligation the trust has to the holder of the trust preferred security in the case of a bankruptcy of the company that issued the underlying bonds, for instance.

AJ
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