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The countdown has begun. Not to the Presidential Election, although that is fodder for another article, but the countdown to the so called "Fiscal Cliff" is closing in on the point of no return. Don't be lulled into any false sense of security that the stars will align and everything will be fine and dandy. The "Fiscal Cliff" is real, and it will happen.

The repercussions of the tax changes will be felt everywhere. From businesses to individuals. There will be no escape if all of the changes go into effect and are kept in effect.

The Changes

The best way I know how to explain the tax changes is by borrowing a chart from this article:

(click to enlarge)Countdown to a Tax Hike

The "biggie" for our purposes, is the increase in the dividend tax rate from 15% to a top level of 39.6%. That could mean a whopping 160% increase in tax exposure for a bunch of taxpayers who earn income from dividend producing stocks.

What that means is that dividends will basically have the same maximum tax as regular income. Regular, or earned income, has a maximum tax rate of 35% currently but will increase to 39.6%. That means dividends will be taxed at virtually the same rate as regular income.

Most folks do not earn enough to be in the top tax brackets, so the maximum is simply a number to be aware of. The increase in dividend taxes will no longer be capped at 15%, which means if you are paying 25% in taxes, you will pay 10% more on your dividend income tax rate in 2013, to be paid in 2014. This assumes nothing changes and the taxes increase.

Long term capital gains will be taxed at a maximum of 20% from the current 15% as well. Of course a capital gain can be offset by losses, but dividends are the most vulnerable aspect of the tax changes for investors.

The impact on our economy might even be the most frightening. Take a look at this chart to see what all the tax changes will cost taxpayers.

$720 billion in tax increases equates to nearly 5% of our GDP. That will be like repealing the entire TARP rescue plan for our economy of $800 billion initially. With a tepid recovery of under 2% growth, how the heck will the economy swallow this mess? It remains to be seen, but I think there are several likely scenarios.

  • Congress will rush to pass some sort of legislation after the election, to extend most of the Bush tax cuts until they can figure something out.
  • Congress will do nothing until AFTER the changes go into effect, but will take action that would be retroactive back to January 1st.
  • Just before the election, the current administration will cave in and authorize the extension of the tax cuts, until the new Congress can work out a plan for the long term. (A nice political move by those who can do it, right?)

I do not think, given our current economic quagmire, that the bobbleheads in Washington D.C. will just let everything fall to pieces by keeping the tax changes, and do nothing. I cannot wrap my head around that stupidity, but it is out there I suppose.

As Investors, How Can We Take Charge?

Unfortunately, there is not much that we can do. Yes, we can sell stocks now, lock in gains and stuff our mattresses, but then what? I do not believe dividend investing will end, nor do I believe for a nano second that companies will stop paying dividends.

As noted in this article, dividends (the ones paid by the companies themselves) will be safe from the "Fiscal Cliff":

"In 2003, when the tax on dividends was slashed from 38% to 15%, dividend payouts increased from $25 billion to $33 billion by 2005. This led many investors to conclude that dividend performance and lower taxes were linked.

As it turns out, though, the tax cuts didn't cause the uptick…

"Dividend payouts would have risen substantially even in the absence of the tax cut," according to a study by the Fed this year.

Instead, the Fed concludes that it was the surge in corporate profits - not tax treatment - that drove dividend payouts higher. In fact, some of the biggest dividend growers at the time were REITs, which didn't benefit from the tax cuts at all."

OK, so the study shows that companies will keep paying dividends. I suggest everyone read the article noted above for some further information, but I completely agree. Why would a company stop paying a dividend just because an individual faces a higher tax? If they did that, investors might just sell the stock. It does not make sense to me.

If companies will continue paying dividends, and continue growing them, we as investors should not run from them, no matter what the tax situation is. That being said, we do have a difference in potential tax liability, from 15% up to the maximum of 39.6%.

I think we can mitigate at least a percentage of this tax hit by increasing our investments into the one area of the stock market that faces no tax changes other than to our regular earned income - REITs.

A Basket Of REIT Stocks Could Help Offset The Tax Bite

Since REITs pay dividends under the IRS tax code, which has strict guidelines for companies that have REIT status, they must pay out a minimum of 90% of their earnings to investors in the form of dividends.

Those dividends have not, and will not, be treated the way ordinary dividends are. Taxpayers have paid, and will continue to pay, tax on these dividends as regular income. In reality, REITs will not be impacted.

By building a basket of REIT stocks right now, with no more than 20% of available investable funds from existing dividend paying stock holdings, an investor can avoid the tax changes in a moderate way. The increased yield, and most folks real tax bracket, could reduce our overall exposure to the tax changes. At the same time, if the basket of REIT stocks is wisely put together, investors might enjoy an even larger income stream.

Here is a "basket" of 8 REIT stocks that I happen to like right now, and their basic fundamentals:

Annaly Capital (NYSE:NLY): Price: $17.31/share, Dividend Yield: 12.75%, ESS Rating: Neutral

  • The largest mREIT in the US.
  • The longest track record of strong results than any other mREIT.
  • The most experienced management of any mREIT.
  • Operating margins over 60% with a very conservative business model.

American Capital (NASDAQ:AGNC): Price: $34.84/share, Dividend Yield: 14.45%, ESS Rating: Bullish

  • More aggressive leverage than other mREITs.
  • Highly disciplined approach during the current interest rate environment to maintain high dividend payments.
  • Operating margins of nearly 90% (this reflects the greater use of leverage of course).
  • An extremely low trailing P?E ratio of about 9.3 (forward PE ratio numbers are not available yet)

Realty Income (NYSE:O): Price: $42.13, Dividend Yield: 4.40%, ESS Rating: Neutral

  • 14% YOY revenue growth and 10% YOY earnings growth.
  • Operating margin of almost 61%.
  • Over 500 consecutive months of dividend payments.
  • Leases retail space to large retail chain operations.

Government Properties Income Trust (NYSE:GOV): Price: $22.59/share, Dividend Yield: 7.50%, ESS Rating: Neutral

  • Low forward P/E ratio of 10.46.
  • YOY revenue growth of over 19% and YOY earnings growth of almost 10%
  • Almost 77% of outstanding shares are held by insiders and institutions (actually 21% of shares are held by insiders, which is amazing)
  • A small premium to book value of about 1/4%

Medical Properties Trust (NYSE:MPW): Price: $10.31/share, Dividend Yield: 7.85%, ESS Rating: Bullish

  • YOY revenue growth of 48% and an astonishing 631% increase in YOY earnings.
  • Operating margins of almost 60%.
  • A low forward P/E ratio of 10.3%.
  • The healthcare industry continues to grow in every area.

Omega Healthcare Investors (NYSE:OHI): Price: $24.02/share, Dividend Yield: 7.00%, ESS Rating:Bullish

  • Low forward P/E ratio of 11.03.
  • YOY revenue growth of 15% and YOY earnings growth of 71%.
  • 90% of outstanding shares are held by institutions.
  • Healthcare industry.

Sabra Healthcare (NASDAQ:SBRA): Price: $19.17/share, Dividend Yield: 7.00%, ESS Rating: Bullish

  • Nursing home facilities, assisted living facilities, independent and continual care facilities, are a growing business sector, and will continue to grow.
  • YOY revenue growth of 33% and YOY earnings growth of 183%.
  • 84% of outstanding shares are held by institutions.
  • A low forward P/E ratio of 11.34.

National Retail Properties (NYSE:NNN): Price: $31.06/share, Dividend Yield: 5.10%, ESS Rating: Bullish

  • YOY revenue growth of 21% and YOY earnings growth of 57%.
  • Forward P/E ratio of 17.07.
  • 89% of outstanding shares are held by institutions.
  • An extremely low BETA of .43

This is a well diversified basket of REIT stocks. It could offer an average yield of roughly 8% (equally allocated). I would consider selling underperforming stocks, whether they are paying dividends or not, and allocating those funds into a basket like this over the course of the next four months.

In this way, you could either lock in some profits now, unload some "losers" to offset capital gains if needed, and rebalance your portfolio to pay higher rates of return, without being affected by the dreaded "Fiscal Cliff."

My Opinion

I am suggesting these stocks for everyone to take a look at, and see if they are to your liking. The diversity of the REIT stocks noted here, make it less risky and could enhance your overall portfolio.

I would not put more than 20% into this basket, and I would allocate each stock equally.

Perhaps we could take matters into our own hands in some small way to make a difference for ourselves.

Source: Fight The Fiscal Cliff With A Basket Of REIT Stocks