What is substitute income?
When a security pays a cash distribution while your shares are on loan, that income is treated as substitute income, also referred to as substitute payment in lieu of dividends.
How is substitute income taxed?
Substitute income may be treated differently than dividends, interest, or any other type of income for tax purposes. If a security pays qualified dividends, but you receive substitute income instead, you cannot claim reduced tax rates normally applied to qualified dividends. Substitute income is taxed at your ordinary rate.
Per IRS guidance, substitute income is taxed as ordinary income even if dividends are classified as another type of income.
Different dividend income classifications include the following:
Exempt-interest dividend
Capital gain dividend
Return of capital distribution
Dividend subject to a foreign tax credit
Tax-exempt interest.
Note: Substitute income will be reported on tax form 1099-Misc.
Why does my statement show substitute income?
At M1, you can receive substitute income in two different situations:
Your fully paid shares are on loan when the security pays a cash distribution.
You have an outstanding margin balance and your shares have been rehypothecated when the security pays a cash distribution.
Learn more about Fully Paid Securities Lending (FPSL) at M1
What is rehypothecation?
When margin is extended in your account, shares in your account are hypothecated, or pledged, as collateral. M1 can then repledge, or rehypothecate, that collateral for financial transactions and activity.
Note: Rehypothecation can occur regardless of if the margin balance is used to purchase securities or withdrawn as cash from the account.
How many of my shares can be rehypothecated?
The amount of shares rehypothecated from each account is limited to 140% of the value of your margin loan. For example, if you have an outstanding margin balance of $1.00, M1 is allowed to rehypothecate $1.40 worth of your holdings. The greater your outstanding margin loan, the more dividends may be paid to you as substitute income.
Note: This limit is specified by SEC Rule 15c3-3.
How can I avoid substitute income?
To avoid receiving substitute income, you will need to opt-out of the fully-paid securities lending (FPSL) program and have no outstanding margin balance in your account
How can I opt out of fully-paid securities lending (FPSL)?
You can opt-out of participating in fully-paid securities lending at any time by sending an email to M1 at [email protected] with “Securities Lending Opt-Out” as the subject line. Please include the last 3 digits for each account number you would like unenrolled.
M1 Finance, LLC does not charge commission, trading, or management fees for self-directed brokerage accounts. You may still be charged other fees such as M1’s platform fee, regulatory fees, account closure fees, or ADR fees. For a complete list of fees M1 may charge visit M1’s Fee Schedule.
All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future performance. Using margin can add to these risks. Users utilizing APEX cleared margin accounts should review the APEX margin account risk disclosure before borrowing. Users utilizing M1 cleared margin accounts should review the M1 margin account risk disclosure before borrowing. M1 Margin Loans are available on margin accounts with at least $2,000 invested per account. Not available for Retirement or Custodial accounts. Margin rates may vary.
Brokerage products and services are offered by M1 Finance LLC, Member FINRA / SIPC, and a wholly owned subsidiary of M1 Holdings, Inc.
M1 disclosures here.
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