REITs, Retirement And The 'Fiscal Cliff'

 |  Includes: NLY, O, REM
by: Regarded Solutions

Focus is now being placed on the expiration of the Bush tax cuts at the end of this year. The issue needs to be planned for by everyone and it is vital to know the facts. While it is absolutely a fact that on January 1st 2013 all taxes will be raised, most people do not even know how much, if at all, they will be affected.

What Are The Facts?

  • Current tax filers will have their capital gains and dividend tax rates increased from the current 15% to a maximum of 23.8% on capital gains and a maximum of 43.4% on dividends. The rates will be applied based on the tax payers' adjusted gross income.
  • Included in that is a 3.8% surcharge tax to help offset the costs of the Affordable Care Act, but that will be paid by couples with an adjusted gross income of $250,000 or more and $200,000 for single filers. Given that fact you can instantly reduce the top rates to 20% and 39.6% if you are under the income threshold.
  • If Congress passes temporary or long term relief, then the top tax rate will be 18.8% on both capital gains and dividends.
  • A recent Wall Street Journal article noted about the 3.8% surcharge: "The new levy's ramifications extend far beyond the end of the year, however, and will be a game changer for many taxpayers. In the future, affluent investors will need to manage both their adjusted gross income and their investment income in order to minimize this tax," says CPA Dave Kautter of American University's Kogod Tax Center.

The article further states:

"Absent guidance from the IRS, experts believe the tax applies to dividends; rents; royalties; interest, except municipal-bond interest; short- and long-term capital gains; the taxable portion of annuity payments; income from the sale of a principal home above the $250,000/$500,000 exclusion; a net gain from the sale of a second home; and passive income from real estate and investments in which a taxpayer doesn't materially participate, such as a partnership."

The big question is how will all the increases actually affect us? Well, I cannot explain it any better than that same Wall Street Journal article:

Here are 4 examples of how the tax surcharge could affect us:

Example 1: A married couple filing jointly has $400,000 of adjusted gross income - $240,000 of wages plus $160,000 of investment income composed of interest, dividends and net gains from the sale of raw land. Because they have $150,000 of investment income above the $250,000 threshold, they would owe an extra 3.8% of that amount, or $5,700, in tax.

Example 2: A retired couple filing jointly has no wages but does have taxable IRA payouts of $100,000, plus pension and Social Security payments totaling $60,000. They also have dividends and taxable interest of $40,000, plus $40,000 from the sale of two investments. They owe nothing, because their income is below the $250,000 threshold.

Example 3: A single taxpayer earns $60,000 of wages but nets a windfall of $180,000 from the sale of a long-held investment. Because she has $40,000 of investment income above $200,000, she owes $1,520 of extra tax.

Example 4: A single taxpayer has income of $220,000, but all of it comes from Social Security benefits and pension and regular IRA payouts. None of the income is subject to the 3.8% tax.

OK, all this being said, we still face the increases in capital gains and dividend taxes right? What do we do?

This article written by Linda Stern of Reuter's spells it out quite clearly so I hope you take a moment to read it. The bottom line being that preparing for this event will be critical to your retirement.

Steps To Take

Move funds from regular IRAs to ROTH IRAs. Have a tax deferred plan to withdraw funds to minimize your taxable withdrawals into the future. Review your portfolio to include some municipal bonds. Delay taking Social Security for as long as possible (Remember that Social Security is taxed, plus delaying it means you will get more). Think of moving to a state that has a favorable tax structure, such as Florida.

Another interesting fact to note is that investments in any REIT will NOT be affected by the dividend tax increase because you are being taxed on that income as ordinary income not as dividend income.

In order for the REIT to maintain it's tax free status, they must pay out at least 90% of profits in the form of dividends to shareholders. What many might not even realize is that the shareholders are footing the tax bill for the REIT.

Obviously it is a win win situation now, and with the tax laws ready to change it becomes even more desirable, especially if you have an adjusted gross income of under $250,000 ($200,000 for single filers).

It would, and could, be a wise idea to adjust your retirement portfolio to add a REIT or two. The 2 REITs I happen to like are Annaly (NYSE:NLY) and Realty Income (NYSE:O), but a sound portfolio can be made up of a variety of REITs within different sectors. A certain percentage - I would say 10-20% of available funds - can be placed in a diversified REIT portfolio or even the new ETF, iShares NAREIT (NYSEARCA:REM) for extended diversification and strong dividends.

I prefer selecting my own REITs but keep REM in mind for mortgage REITs at least.

My Opinion

I personally do not think that Congress will let any taxes increase for anyone, especially for those earning $250,000 or less. Yes, we have a dysfunctional Congress and no matter who is elected it probably will remain that way, but given our economy and history of corporate bailouts, I firmly believe that we will have a more sane tax situation either temporarily or permanently.

That does not mean we shouldn't be prepared and have some sort of strategy in place just in case. What I have noted here are some good starting points.

I am not a tax expert, do not claim to be, nor can I offer any sort of tax advice, so PLEASE consult with your tax advisor before taking ANY steps, to evaluate your own personal situation.

Disclosure: I am long NLY, O.