mREITs: Golden Era Or Dark Age?

| About: Annaly Capital (NLY)

In my previous article, I discussed how changes proposed in the Obama Administration's new business tax plan could affect the tax treatment of dividends. Specifically, I wrote that the potential increase in taxes on normal dividends would make the high yields of MREITs even more attractive. However, as a commenter mentioned, there is also language in the tax plan that is a bit ominous and alludes to potential problems for MREITs in the future.

While this potentially-threatening change is discussed more generally than the proposed increase in dividend tax rates, the Administration and the Treasury do specifically discuss the target of the change; pass-through entities are a target for increased taxation. While the plan does not specifically call out trusts (which MREITs are), it opines that "S-corporations, partnerships and sole proprietorships" do not pay taxes at a high enough rate. The report supports that accusation by noting that pass-through entities represented less than 25% of overall business income in 1980, but make up about 70% today. Supposedly, this puts C-corporations at a competitive disadvantage. (Never mind the fact that millions of small business have been organized and prospered under the advantageous pass-through rules, and countless individual investors have become financially independent because of the dividends provided by MREITs and MLPs.)

If the administration is successfully able to adjust the tax code to "level the playing field" in way that affected trusts and partnerships, MREIT investors would be negatively affected. The current code enables MREITs to avoid taxation at the corporate level if >90% of income is paid in dividends; this is what allows companies to pay such large dividends. Individual investors are then taxed at ordinary income rates, though tax burdens can be managed by using vehicles like Roth IRAs. If the tax code changed to force MREITs to pay taxes at a corporate level and also made individuals pay taxes on dividends received, real yields would drop substantially. The following table models a few different theoretical situations that would affect the realized dividend of Annaly Capital Management (NLY).

MREIT yields based on obama tax code

This first column approximates the corporate and high-income taxpayer tax implications based on current tax laws. There is no tax paid at the corporate level, and the individual pays about 35% (federal) tax on the dividend, resulting in a net yield of about 9%.

Scenario 1 is a hybrid of potential tax code changes; it is the result of an imposition of corporate-level taxes upon MREITs while maintaining the current lowered rates on dividend income. In that scenario, the net yield would fall by about 15% to 7.7% - that would certainly be unwelcome, but it's not necessarily a game-changer for MREITs.

Scenario 2 is a scarier situation that would be the result of total tax code reform as laid out (or implied) in the new tax plan. Pass-through entities would lose their advantages, but corporate rates would also drop to the proposed 28%; however, individual tax rates would increase to roughly 40%. This would reduce the yield realized by a NLY holder by about 33% to just 6%. At that level, MREITs would become less attractive as an investment class, as some stocks like Altria (NYSE:MO) yield at similar levels while potentially providing greater capital appreciation.

This worst-case scenario would generally affect all MREITs equally. Securities that would be affected include: Annaly Capital Management, American Capital Agency (NASDAQ:AGNC), Chimera Investment Corp (NYSE:CIM), Invesco Mortgage Corp (NYSE:IVR), American Capital Mortgage (NASDAQ:MTGE), and a MREIT index fund, (NYSEARCA:REM). It would also affect other publicly-traded securities that are structured similarly, such as Master Limited Partnerships.

However, I believe that such a drastic change is unlikely. Sure, the Administration and Treasury would enjoy double-taxing the millions of pass-through entities, including everything from pizza parlors to public accounting firms, but raising taxes so substantially on such a broad group that is responsible for a large percentage of the economy would be foolish. Therefore, I do think that the previously-discussed Golden Era is more likely to occur than a Dark Age, though the massive inertia of tax policy means that any change (especially around a major election) is not likely in the immediate future.

But the multiple uncertainties of tax proposals and the clearly-recognized craving for additional government revenue means that investors should expect difficulties in the future. As most financial planners or finance textbooks would assert, diversification is the best hedge against uncertainty, and I think that most people reading this article hold more than just REITs in their portfolios. REITs and MLPs are great vehicles to generate a lot of dividend income, but wise investors should be prepared for potential changes by maintaining a broad portfolio and proactively addressing threats to their financial well-being.

Disclosure: I am long (NYSE:NLY), (NYSE:TCP).