Tax Treatment of Investment Products

Now that you know the underlying securities, you can see how the tax code handles the income they produce. The unifying concept is the pipeline (also called conduit) theory under Internal Revenue Code Subchapter M: a regulated investment company passes income through to shareholders without paying tax at the fund level.

How does Subchapter M conduit theory work?

Under Internal Revenue Code Subchapter M, a regulated investment company (mutual fund, closed-end fund, UIT, ETF) is a pass-through entity for tax purposes.

• Income and realized gains distributed to shareholders are taxed to the shareholders, not to the fund
• To qualify, the fund must distribute at least 90% of its net investment income to shareholders
• The fund acts as a conduit or pipeline: earnings flow through to investors without a corporate-level tax layer
• Distributions retain their character:
  • Interest income passes through as ordinary income
  • Qualified dividends retain preferential Long-Term Capital Gain (LTCG) rates
  • Long-term capital gains retain LTCG rates

Think of it this way: A regular corporation pays corporate tax on its profits, then shareholders pay dividend tax on what is left. That is double taxation. A Subchapter M fund skips the corporate layer entirely. The tradeoff: the fund must distribute nearly everything it earns, which is why mutual funds send out 1099s every year.

Exam Tip: Gotchas

• The magic distribution threshold is 90% of net investment income, not 100%. Most funds distribute 98-99% in practice to avoid a 4% federal excise tax, but the Subchapter M qualification line is 90%.
• Distributions keep their character. A fund cannot convert non-qualified income into qualified dividends. What goes in determines what comes out.

How are capital gains and losses taxed?

Capital gains occur when a security is sold for more than its cost basis. The tax rate depends on how long the security was held.

Netting capital gains and losses (in order):

1. Net short-term gains and losses against each other
2. Net long-term gains and losses against each other
3. Net the two remaining totals together

Excess loss deduction:

• Up to $3,000 per year deducts against ordinary income
• $1,500 for married filing separately
• Unused losses carry forward indefinitely to future tax years

Exam Tip: Gotchas

• Net within holding period first, then across. The two-step netting is a common exam trap: you cannot skip to the total.
• Only $3,000 of net capital loss deducts against ordinary income per year. The remainder carries forward indefinitely; the carryforward retains its short-term or long-term character.

What is the difference between qualified and non-qualified dividends?

Not all dividends are taxed the same. The qualified dividend label unlocks preferential LTCG rates.

Holding-period test for qualified dividends (common stock):

• Hold the stock for more than 60 days during the 121-day window that begins 60 days before the ex-dividend date

Always non-qualified:

• Real Estate Investment Trust (REIT) dividends
• Money market fund dividends
• Dividends on short-sold positions

Pass-through principle:

• A fund cannot convert non-qualified income into qualified dividends
• Fund distributions pass through the character of the underlying source

Exam Tip: Gotchas

• Money market fund dividends are NOT qualified even though they are called dividends. Money market funds hold short-term debt, so the "dividend" is really pass-through interest income.
• REIT dividends are NOT qualified even though REITs are often held in equity portfolios. REITs already pay out pre-tax income under their own pass-through structure, so qualified-dividend treatment would create a double tax benefit.

What is the wash sale rule?

Internal Revenue Code Section 1091 disallows a loss if the same (or substantially identical) security is repurchased within a short window around the sale.

• 61-day total window: 30 days before the sale + day of sale + 30 days after the sale
• Disallowed loss is added to the cost basis of the replacement security
• Holding period carries over: the replacement share inherits the original holding period
• The rule applies across accounts the taxpayer controls, including accounts belonging to a spouse or controlled corporation
• Applies to mutual fund share purchases the same way: buying into a substantially identical fund triggers the rule

Think of it this way: The wash sale rule does not erase the loss forever. It defers the loss by baking it into the cost basis of the new shares. When the new shares are eventually sold outside the window, the deferred loss comes back as a larger capital loss (or smaller gain).

Exam Tip: Gotchas

• The wash sale window is 61 days total: 30 before + day of + 30 after. Selling at a loss on December 15 and rebuying on December 28 triggers the rule even though both trades are in the same tax year.
• The loss is deferred, not erased. The tax benefit gets baked into the replacement share's cost basis and carries over the holding period.
• A wash-sale loss inside an Individual Retirement Account (IRA) is permanently lost. Since IRAs have no cost basis adjustment, the deferred loss has nowhere to go. This is why "buying the identical fund in your IRA within 30 days of selling it in your taxable account" is a disaster.

How are holding periods determined for tax purposes?

The holding period determines short-term vs. long-term treatment.

• Holding period begins the day after the trade date (acquisition)
• Holding period ends on the trade date (disposition)
• Inherited securities: automatically long-term regardless of how long the decedent held them
• Gifted securities: donor's holding period carries over to the donee (along with the donor's cost basis for gain calculations)

Exam Tip: Gotchas

• Inherited securities are always long-term. This pairs with the step-up in cost basis to date of death (or alternate valuation date) to make inherited stock especially tax-favored.
• Gifted securities carry over the donor's holding period. A gift of stock the donor held 10 months becomes long-term only after an additional 2+ months in the donee's hands.