Explanation of Dividend Stripping

Dividend stripping is the process of purchasing a security just before it pays out dividends, and then selling it immediately once the dividend has been paid. This process results in a gain to the purchasers in the sum of the dividend. It also, however, likely results in a loss when the shares are sold back because they will be valued lower immediately after paying out a dividend. If the capital earned from the dividend is higher than the drop in price, the purchaser nets a profit.

Capital Loss Write-Off

For many years, this strategy was dually beneficial. Not only would the owner gain the dividend, they could write off the loss at the time of sale through a capital loss strategy. This could offset a certain degree of short-term capital gains in other investments. For years, using dividend stripping to both profit and reduce tax liability was a popular model. As of 2003, however, it is no longer possible to write off a capital loss if the asset is purchased and sold back within three months. This is to prevent individuals and companies from using the dividend stripping model to avoid paying taxes.

Corporate Dividend Stripping

On the corporate level, dividend stripping was a model for paying business owners through capital gains rather than using a salary. In this model, the company would purchase its own shares right before dividends were paid. Those dividends, then, would be handed over to associates and owners. The shares would be sold back at the depreciated price. The owners would benefit by the lower taxation applied to the capital gains than to a bonus. The corporation as a whole would benefit by writing off the capital loss. Since this write off is no longer possible, the IRS has closed the gap on corporate dividend stripping because of tax avoidance.

When to Use Dividend Stripping

Since dividend stripping no longer can supply tax avoidance, it is less attractive than it formerly was. Even so, it can be an attractive profit option. Dividend stripping can be effective when the purchaser believes the dividend about to be paid will be higher than the loss incurred at the time of sale. For example, Stock A is currently trading at $10 and will shortly pay a dividend of $3. John buys Stock A, collects the dividend, and looks to sell it back to another owner. The current market price is $8. Even though he will lose $2 on the sale, John has made a profit of $1 through dividend stripping.

When to Avoid Dividend Stripping

Dividend stripping is a highly risky gamble. You will be taxed on the dividends earned at a higher rate than you will be taxed on your other investments. Sine the write off no longer applies, you will have no tax benefit on the back end. The affect of this tax and the loss due to trading at a lower cost will almost always offset a dividend gain unless you find a rare successful opportunity. 

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