The Taxman Cometh: A Look At The Tax Efficiency Of REITs

| About: Vanguard Real (VNQ)
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Taxes are an inevitable component of every investment. Investors should be aware of the tax efficiency of their investments and seek to maximize after-tax returns, not minimize taxes paid.

While REITs are less tax efficient than qualified dividend-paying US equities, the extent of their inefficiency is overstated and misunderstood.

REITs pay out roughly 65% of their distributions as ordinary income. The remaining 35% is taxed at advantaged rates including 15% that is tax-deferred.

Many investment advisors completely avoid REITs in taxable accounts, often to the detriment of the overall portfolio. These investors have missed out on the best performing asset class.

For the average investor, the slightly higher effective tax rate on REITs (19% vs 15%) is outweighed by the diversification and operational advantages of holding REITs.

Albert Einstein is famously quoted,"The hardest thing in the world to understand is the income tax."

The US government employs over 22 million people, twice that of the entire manufacturing sector, and loves to use stock investors as a continued revenue source. Taxes are an inevitable but complicated component of every investment. From this complexity emerges common investment heuristics, some of which are oversimplified or downright incorrect.

A common refrain that we hear is related to the tax efficiency (or inefficiency) of REITs, which pay high dividends, most of which are taxed at ordinary income rates much like a typical bond portfolio. Dividends from US equities, on the other hand, tend to be entirely composed of "qualified dividends," which are taxed at advantaged rates.

Many investment advisors, including robo-advisors like Wealthfront, completely avoid REITs in taxable accounts for this reason. The justification for the exclusion, though, is often based on a faulty premise and an oversimplified understanding of REIT taxation.

In Wealthfront's blog post, "Why You Should Exclude REITs from Taxable Accounts," we can see how oversimplification of assumptions leads to poor investment decisions. In the post, the company makes two faulty assumptions: that REIT distributions are 100% ordinary income, and that an "average" investor pays an average tax rate on ordinary income of 43%.

We set out to correct this misinformation and show that, for the average investor, the effective tax rate for REITs is only slightly higher than a portfolio of US equities paying qualified dividends, and significantly lower than a portfolio of bonds.

While every individual's tax situation is unique, we conclude that investors would be unwise to completely avoid an entire asset class for a relatively negligible tax savings. Investors that avoided REITs for this reason have foregone significant after-tax outperformance.

How REIT Distributions Are Taxed

Contrary to conventional investing wisdom, REITs are not taxed entirely at ordinary income rates. Using data from NAREIT and tax-related information from Vanguard's REIT ETF (NYSEARCA:VNQ), we can see that only about 65% of distributions are ordinary income in the average year. The remaining 35% is taxed at lower advantaged rates, including an average of 15% that is a tax-deferred return of capital.

Much of the misunderstanding related to REIT taxation is related to a misinterpretation of REIT laws. To qualify as a REIT, the company must distribute at least 90% of its taxable net income annually to its shareholders. By doing so, the REIT avoids double taxation at the corporate level. The trade-off is, of course, that investors pay slightly higher rates on that distribution.

It is common to assume that, like bonds, REITs are primarily current rather than future income investments, as they pay out nearly all of their earnings in any given year. There's nothing left to reinvest to grow the business, according to this belief.

The large impact of depreciation on REITs, though, means that GAAP net earnings are a poor indicator of a REIT's true cash earnings. On a cash basis, REITs tend to pay out closer to 75% of earnings, roughly in-line with the payout ratio of typical high-yielding companies. Operationally, REITs are no more bond-like than companies like Microsoft, GE, and Johnson & Johnson and have ample earnings power to reinvest in the business.

There's another curve ball related to the effects of deprecation on REITs. Since "net income" is only loosely related to the REIT's true cash earnings, there are often situations when REITs distribute more than they make from an accounting perspective.

When a REIT distributes $2 per share on net income of just $1 per share, this gives rise to this oddity in taxation, return of capital. Return of capital reduces the cost basis of the investment and thus the tax is deferred until the investment is actually sold. Roughly 15% of REIT distributions qualify as return of capital in the average year.

Another 15% of REIT distributions qualify as long-term capital gains, which for most investors are taxed at an advantaged rate of 15%. Distributions that result from the REIT selling assets for a gain fall under this category.

The remaining 5% are conventional "qualified dividends," which are also taxed at advantaged rates, often 15%. Earnings from non-REIT subsidiaries of REITs (which pay corporate taxes) give rise to qualified dividends.

Effective REIT Taxation for A Typical Investor

Every investor has a unique tax situation. This simplified example is by no means applicable to everyone, but it does highlight an important point and corrects a common confusion related to REITs.

We assume that this "average" investor has a pre-tax annual income of $100,000 per year. After deductions, we assume that she is paying an average tax rate on ordinary income of 25% and thus pays 15% on qualified dividends and long-term gains. She has a portfolio of $1 million, all of which is in a taxable account. She has allocated 10% of her portfolio to REITs in the VNQ ETF.

From this REIT Tax Worksheet, we can see that, for this investor, the effective tax rate on REIT distributions is actually 19%, only slightly higher than the 15% qualified dividend rate, and short of the 25% tax rate on bonds. All in, the annual "percentage cost" of holding REITs versus holding a basket of qualified dividend investments is a mere 15 basis points per year, or 0.15%.

The dividend yield of the two major REIT ETFs, VNQ and IYR, hovers around 3.5%. To achieve comparable after-tax yields using investments with similar risk-profiles, investors are limited in their options. For qualified-only dividends, the closest alternative would be the Vanguard High Dividend ETF (NYSEARCA:VYM), which yields 3.1% -- still less than the REIT ETF on an after-tax basis. From a bond-perspective, investors would need to buy a mix of investment grade bonds (NYSEARCA:LQD) and high yield bonds (NYSEARCA:JNK) to achieve similar after-tax yield.

Outperformance Foregone In The Name of "Tax Efficiency"

Let's continue the example from above and assume that this yield-seeking investor was faced with this exact decision. The investor has already maxed-out her tax-advantaged retirement accounts with bonds, and is deciding between REITs and high dividend stocks that pay qualified dividends for her taxable account.

On the advice of the online blog post by Wealthfont, she believes that REITs should not be held in taxable accounts. One year ago, she purchased the Vanguard High Dividend Yield ETF, VYM, rather than the Vanguard REIT ETF, VNQ. On her $100,000 investment, she saved $148 in taxes… but at the cost of nearly $10,000 in incremental gains.

By many measures, REITs have been the best performing asset class of the past two decades, so this effect is amplified as you go farther back in time. If the decision was made at the beginning of 2009, the investor would have saved roughly $1,000 in taxes… at the cost of $70,000 in incremental gains.

We are not saying that a 15 basis-point "drag" on an investment portfolio from incremental taxes is meaningless. The effect of small fees on an investment portfolio quickly add up as they are compounded over time.

We are saying, though, that this cost must be weighed against the incremental diversification benefits of REIT ownership, which have relatively low correlations to both stocks and bonds. Based on NAREIT total return data from 1990-2014, portfolios with a 10% allocation to REITs achieved higher returns with less volatility than portfolios without REITs.

Maximize After-Tax Returns, Don't Minimize Taxes Paid

The goal of every investor is not to minimize taxes, but rather to maximize after-tax returns. It is a subtle but critical difference.

If given the equal choice between a taxable and tax-advantaged account for REIT investments, assuming the investor already has the optimal asset mix, investors should choose the tax-advantaged account, as REITs are slightly less tax efficient than US equities.

If investors are limited to a taxable account and the choice is between holding REITs or not holding REITs, it would be unwise to completely forgo investing in an entire asset class in order to avoid the relatively minor incremental tax borne by the average REIT investor.

The conventional wisdom that REITs are highly inefficient investments is simply not true for the average investor.

With limited information available online about portfolio and tax optimization when it comes to REITs, we hope to have clarified some of the misinformation out there. We encourage readers to follow our Seeking Alpha page to continue to stay up to date on our weekly recaps and analysis on the REIT and broader real estate sector.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.