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If a security pays a dividend, depending on the holding period of said security, the dividend might be considered "qualified" and taxed at a lower rate. What if the security is held with borrowed money (on margin)? Does the tax treatment change? Meaning, regardless of whether it's a qualified dividend, would it lose the tax advantage?

What if the security is a Municipal Bond ETF? Dividends on these ETFs stem from interest payments which makes them completely tax free. Would these dividends lose their tax free status if the ETF is held on margin?

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If you buy a stock, you are entitled to the dividend whether you bought it for cash or you bought it on margin. You're the owner. There is no loss of tax advantage.

The IRS is not notified if you are on margin nor does it care. In this situation, the only additional involvement with them could be:

  • The possibility of deducting the margin interest.

  • If your shares have been loaned out to a short seller and he is short on the ex-div date, the buyer of the borrowed shares receives the dividend. The share lender (you) receives payment-in-lieu (PIL) from the short seller. The downside of PIL is that it does not qualify for the qualified dividend rate and is taxed at ordinary income rates.

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