Equities Trade “Dirty” Causing Investors to Lose Billions (Part 2)

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This is the second article in a three-part series. It is meant to describe a flaw in securities market structure.

In my previous article, I discussed a known risk in our financial markets called "buying a dividend." Buying a dividend is a market-structure risk that costs investors billions in unnecessary taxation. All or a portion of the first dividend, short-term capital gain, and long-term capital gain an investor receives after purchasing an income-producing security represents the return of a portion of their initial investment. This return of an investor's capital should never be taxed. However, the accounting systems used by Wall Street do not account for the portion of these distributions that are a return of capital and instead incorrectly tax 100% of the distribution.

The first article in this series pointed out that the bond markets have an identical problem. However, the bond markets separate the value of the bond (the clean price) from the accumulated interest at purchase. The accumulated interest paid to the seller is deducted from the total coupon payment received on the investor's 1099. Deducting the accumulated interest paid from the total coupon received ensures the bond buyer is taxed accurately based on the interest income they earned. If the buyer is not able to claim this deduction, they will pay taxes on income they never earned. Unfortunately, no such mechanism exists in the equity markets resulting in tens of millions of 1099s produced annually, which overstate your clients' taxes.