There are not many guarantees out there when it comes to investing, especially these days. But there is an often overlooked strategy that for some is a guaranteed return booster. I call this strategy dividends to capital gains conversion.
The idea is this: By taking dividends in the form of capital gains, and then offsetting those gains with capital losses you may have, you can pay an effective tax rate of 0%. Compare this to paying either the 15% rate for qualified dividends (for most people) or your top marginal income tax rate on REIT investments and Master Limited Partnerships (MLPs).
So how does one go about converting dividends to capital gains? It takes some monitoring, but it could very well be worth your time. First let’s define the ex-dividend date for a stock:
The ex-dividend date is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This is an important date for any company that has many stockholders, including those that trade on exchanges, as it makes reconciliation of who is to be paid the dividend easier. It is just as important for investors, however, since you must own a stock before the ex-dividend date in order to receive the next scheduled dividend.
If an investor buys the stock on the ex-dividend date or after, he is not entitled to the next dividend. This also means that if an investor sells the day before the ex-dividend date, he is not entitled to the next dividend.
Given this, an investor can buy a stock the day of the ex-dividend date and sell the day before the next ex-dividend date, and be assured that he will never receive a dividend. Some might be saying, what a horrible deal! But Mr. Market is no dummy. Those who buy on the ex-dividend date and sell the day before the next one will benefit from the stock price climbing by the amount of the dividend during this time. If you ever notice why a stock’s price drops the of the ex-dividend date, this is because those buying it on that day will not receive the next dividend. In fact, the price drops by the amount of the next dividend. Conversely, the stock price will begin climbing the day after the ex-dividend date and will eventually rise by the amount of the dividend. Of course, the price will fluctuate due to other variables, but the amount of the next dividend is always embedded in the price.
Hopefully this all makes sense because for stocks with high dividend yields, this strategy could provide a huge gain for investors. I use this strategy myself for Annaly Capital Management (NYSE:NLY), which currently has a dividend yield of 14.7%. Every quarter I buy NLY on the ex-dividend date and then sell it the day before the next ex-dividend date. I pay no taxes whatsoever on this dividend, yet receive all of the dividend yield in the form of capital gains. I avoid taxes by offsetting the gains with capital losses. This is a huge benefit to me because Annaly is a REIT and investors must pay the full income tax rate on any dividends that are paid.
Let’s look at an example using NLY where an investor buys 3,000 shares of NLY. The combined marginal federal and state tax rate for him is 33%. He is able to offset all capital gains with capital losses and pays $8 per trade. I ran the following using our publicly available calculator called Minimize Taxes by Trading Dividends for Capital Gains and readers are free to run their own scenarios as well.
I will have accumulated over $62,000 more using this strategy. That is a cumulative return that is 130% higher than if I just collected the dividend. I can also adjust the amount of the capital gains that I can offset. Let’s say I can only offset 50% of the gains. Doing this still gives me a higher cumulative return of 189% vs. 156% when not using this strategy.
Because of the monitoring involved and the trading costs, this idea is best suited for those stocks with relatively high dividends. In the example above, if the dividend yield were below 2%, this strategy does not even pay off any more. But for REITs, MLPs, and other high yielding stocks, especially those where dividends are taxed at your income tax rate, this strategy will be a sure-fired winner.
Disclosure: I am long NLY.