Your Financial Advisor Is Wrong About REIT And BDC Dividends

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Includes: KIM, MPW, UNIT
by: Joshua Mou
Summary

Conventional investment wisdom teaches that REIT and BDC dividends are taxed at a much higher rate than other types of investment income.

Conventional wisdom neglects the effect of corporate taxes on investment income.

REIT and BDC investment income have a lower TOTAL tax exposure than C-corp investment income for most individual taxpayers.

The recent Tax Cut and Jobs Act Bill includes a new deduction for qualified REIT dividends, but the IRS needs to clarify the details of this deduction.

“You didn’t buy REITs or BDCs in your taxable brokerage account, did you?”

--Quote by lots of financial advisors and internet bloggers.

For those who have been buying Real Estate Investment Trust (REIT) stocks or Business Development Companies ((BDCs)) in a taxable brokerage account, prepare to be vindicated!

Taxes on C-Corporation Investment Income

Investment income can come in the form of capital gains, dividends, and interest. Each kind of investment income can be taxed differently. A C-corporation (C-corp), which is the most common publicly-traded company, typically pays out dividends that are "Qualified," which are subject to a special lower tax rate compared to individual income. C-corp stockholders can also earn capital gains income on their stock if it is sold for a profit. Long-term capital gains (LT cap gains) are also taxed at the lower tax rate.

Long-Term Capital Gains and Qualified Dividend Tax Brackets

Tax Rate

Single Filer Income

Married Filing Jointly Income

0%

$0 - $38,600

$0 - $77,200

15%

$38,601 - $425,800

$77,200 - $479,000

20%

Greater than $425,800

Greater than $479,000

Table 1: Tax Rates and Income Brackets for Long-Term Capital Gains and Qualified Dividends.

Taxes on REIT and BDC Dividends

Real Estate Investment Trusts (REITs) and Business Development Companies ((BDCs)) are two classes of companies that can avoid corporate taxes. They primarily pay out investment income in the form of "Ordinary Dividends," which are taxed just like ordinary income (paycheck income) from an employer.

Figure 1: Individual Tax Rates for 2017 and 2018, Source https://www.cricpa.com/TaxReform/Individuals/

For a particular income level, ordinary dividends are always going to have more tax taken than LT cap gains/qualified dividends on an individual’s tax return. At face value, it seems to be a no-brainer that C-corp stocks are more tax advantaged than REIT and BDC stocks. Due to this apparently higher tax burden on REIT and BDC investment income, financial advisors usually recommend putting those assets in tax-advantaged retirement accounts such as 401(k)s, IRAs, and Roth IRAs.

Fortunately, the Tax Cuts and Jobs Act Bill (TCJA Bill) signed in December 2017 will reduce all the ordinary tax bracket rates with the top bracket down to 37% beginning in 2018. But, tax bill or not, 37% is still significantly higher than the top qualified dividend rate of 20%. The critics are correct; a 20% tax IS better than a 37% tax . . . if that were the only tax levied on investment income.

REITs and BDCs can also pay out income in the form of qualified dividends, capital gains distributions, and return of capital dividends. Those three forms of REIT and BDC income have more advantageous tax treatment than ordinary dividends, but they typically make up a minority of distributions from REITs and BDCs. This article will not discuss those tax-advantaged distributions, and I refer readers to Dane Bowler’s recent SA article, which describes them well. In this article, I would like to address ordinary dividends from REITs and BDCs in comparison to C-corp LT cap gains and qualified dividends.

Dividend Terminology

Before moving on, it is worth clarifying the different names given to REIT and BDC dividends--the ones that will be discussed in this article.

“Ordinary” dividend means a dividend that is taxed at the investor’s highest individual tax bracket. It is taxed like “ordinary” employment income.

“Qualified” dividend means a dividend that is taxed at a lower scale that tops out at 20%.

“Qualified-REIT” dividend is a new term starting in 2018 that refers to dividends from REITs that are taxed as ordinary dividends. (Leave it to Congress to name something the opposite of what it actually is.)

For clarity, I will use the older term “ordinary” to refer to REIT and BDC dividends that are taxed like ordinary income.

C-Corporation Income Tax

Every dividend originates from a business’s profits. The typical publicly-traded company that pays out dividends is a C-corp. Before 2018, corporations with incomes over $335,000 were subject to corporate taxes around 35%. Corporate taxes make a huge dent in profits that are needed to pay dividends. REITs and BDCs typically do not need to pay corporate tax, and this attribute evens the playing field with C-corps.

Pre-2018 Investment Income Comparison

Pre-Tax Distributable

Income

Corporate Tax Rate

2017

C-Corp Profit

Dividend

Paid to

Investor

Qualified

Dividend

Tax

Total Investment Income

Total

Tax

Rate

35%

100-tax

20%

100 – 35 - 13

$100 Income

- $35

->$65

->$65

- $13

->$52

48%

Table 2: Tax Cycle of $100 of Qualified Dividend income through a C-corp at the highest individual tax rate in 2017.

Pre-2018, C-corp profits were reduced by 35% before they even reached the investor as a dividend. Even if the dividend is taxed at the lower qualified dividend rate of 20%, the overall tax is 48%.

But, C-corp investing is also about long-term capital gains (LT cap gains). Capital gains are directly dependent on market price appreciation. Price appreciation is, in turn, based on supply and demand for the stock. It is not dependent on corporate profits . . . or is it? Those that are holding for long-term price appreciation are doing so because they believe the underlying profits will go up, which does lead to the price going up proportionally. That is why price-to-earnings ratios (PE ratio) are ubiquitous to stock investing.

Pre-Tax

Earnings:

$100

No Corporate

Tax

After Tax

Earnings:

->$100

Average

S&P 500 PE

Ratio: 25

Stock Value

(No Corp Tax):

$2,500

Pre-Tax

Earnings:

$100

35% C-Corp

Tax

After Tax

Earnings:

->$65

Average

S&P 500 PE

Ratio: 25

Stock Value:

(35% Corp Tax)

$1,625 (35% less)

Table 3: Effect of Corporate Tax on Stock Price and Capital Gains.

When corporate taxes decrease a company’s earnings, then the price decreases as well. Therefore, corporate taxes do affect capital gains, especially over the long-term.

Pre-Tax

Capital

Gain

Corporate Tax Rate

2017

After-tax

Capital

Gain

Cap Gain

Paid to

Investor

LT Cap Gain

Tax

Total Investment Income

Total

Tax

Rate

35%

100-tax

20%

100 – 35 - 13

$100 Cap Gain

- $35

->$65

->$65

- $13

->$52

48%

Table 4: Tax Cycle of $100 of capital gains income through a C-corp at the highest individual tax rate in 2017.

The resulting tax rate is expected to be roughly the same as that for qualified dividends from a C-corp. I concede that the corporate tax effect can vary depending on if one purchased at lower PE ratio and sold at a higher PE ratio and vice versa. But, on balance, this is the typical effect on capital gains.

Look now at the much maligned ordinary REIT or BDC dividend.

Pre-Tax Distributable

Income

Corporate Tax Rate

2017

REIT or

BDC

Profit

Dividend

Paid to

Investor

Qualified

REIT or BDC Div. Tax

Total Investment Income

Total

Tax

Rate

0%

100%

39.6%

100–39.6

$100 Income

- $0

->$100

->$100

- $39.6

->$60.40

39.6%

Table 5: Tax Cycle of $100 of Ordinary REIT or Ordinary BDC Dividend income at the highest individual tax rate in 2017.

The overall tax rate for ordinary dividends from a REIT or BDC was identical to the marginal tax bracket of the investor, which would top out at 39.6% pre-2018. A 39.6% tax is arguably better than a 48% tax, so the REIT/BDC dividend wins.

Running a more typical scenario for the average taxpayer that is married and filing jointly with about $60,000 in household income, a C-corp qualified dividend or LT cap gains income would have incurred 35% total tax. The same household would have paid 15% in ordinary REIT or BDC dividends pre-2018. It is still no contest. REIT and BDC investors who have been using taxable accounts can hold their heads up high.

Post-TCJA Bill Investment Income Tax Comparison

Starting in 2018, the TCJA Bill will lower the corporate tax to a flat rate of 21%. Personal tax brackets have been adjusted and tax rates have decreased across the board. The qualified dividend and LT cap gains brackets and rates (0%, 15%, & 20%) have not changed. Here is how the investment income comparison shakes out in 2018. First up is C-corp qualified dividends:

Pre-Tax Distributable

Income

Corporate Tax Rate

2017

C-Corp Profit

Dividend

Paid to

Investor

Qualified

Dividend

Tax

Total Investment Income

Total

Tax

Rate

Top Tax Rate

21%

100-21

20%

100–21-15.8

$100

Minus $21

->$79

->$79

Minus $15.80

->$63.20

36.8%

Table 4: Tax Cycle of $100 of C-corp qualified dividend income at the highest individual tax rate in 2018.

One can see that reducing the corporate tax rate drops high earners from 48% last year to 36.8% total tax, which is significant. C-corp LT cap gains will also see total tax of 36.8%. For the married-filing-jointly household with $60,000 in income, their total tax on qualified dividends and LT capital gains drops even more from 35% down to 21%.

Ordinary REIT or BDC dividends were never exposed to corporate tax, so that tax cut does not help those dividends. However, the cuts to the individual tax brackets do affect those dividends.

Pre-Tax Distributable

Income

Corporate Tax Rate

2017

REIT or

BDC

Profit

Dividend

Paid to

Investor

Qualified

REIT or BDC Div. Tax

Total Investment Income

Total

Tax

Rate

0%

100%

37%

100–37

$100 Income

Minus $0

->$100

->$100

Minus $37

->$63

37%

Table: 2018 Tax cycle of ordinary REIT & BDC dividends at the highest tax bracket

I have graphed the total tax of both the C-corp investment income types in blue and the REIT/BDC dividends in red. This will make it easy to see which has the higher taxes depending on the taxpayer income.

Figure 2: 2018 Single-Filer Taxpayer’s Total Tax Exposure for C-corp investment income (LT Cap Gains & Qualified dividends) and for REIT/BDC ordinary dividends.

Figure 3: 2018 Married-Filing-Jointly Taxpayer’s Total Tax Exposure for C-corp investment income (LT cap gains & qualified dividends) and for REIT/BDC ordinary dividends.

Finally, conventional wisdom wins out . . . by a whopping 2.15% . . . sometimes.

Notice that for single-filer taxpayers, the REIT/BDC ordinary dividends have higher taxes for income from $200,001 through $425,800. For married-filing-jointly taxpayers, the REIT/BDC ordinary dividends have higher taxes for income from $400,001 through $479,000. At the very highest tax brackets, both income types are tied at 37% tax.

Ordinary REIT/BDC dividends are considerably more tax advantaged for single filer income levels below $150,000 and for married filing jointly income levels below $300,000. Looking at the average married-filing-jointly taxpayer with $60,000 in income, the C-corp investment income will be taxed 21% in 2018. That family’s qualified REIT dividend rate will only be taxed 12%. If that family earned $10,000 of investment income from REIT or BDC ordinary income, then they would have $900 more in their pockets than if their investment income came from C-corp LT cap gains or qualified dividends.

If you would like to see the numbers for your income level, here are links to charts for single-filers and for married filing jointly. Look down the chart for your taxable income, then follow the line to the right to find the expected tax rate for C-corp LT cap gains/qualified dividends and for ordinary REIT/BDC dividends.

Single Filer Investment Income Tax Exposure

Married Filing Jointly Investment Income Tax Exposure

Please note that my data tables and charts will not perfectly mimic real world portfolios, because each stock can produce multiple types of distributions. I assumed that all C-corps would be taxed at the top corporate tax rates, which I know is not true for every company. I also assumed that a REIT or BDC company would have been taxed at the corporate rate if management had opted to be taxed as a C-corp. I did not add the 3.8% ACA Medicare tax that is imposed on high income taxpayers because that tax applies equally to all types of investment income.

Potential REIT Dividend Tax Deduction

The Tax Cuts and Jobs Act (TCJA) Bill of December 2017 seems to have added one more wrinkle into the mix. Many tax specialists and the National Association of REITs (NAREIT) interpret the new law as giving taxpayers a deduction on 20% of their qualified REIT dividends with NO income limitations from the beginning of 2018 until the end of 2025. Here is the interpretation by NAREIT:

Pass-Through Business Rate Lowered through Deduction of 20 Percent of “Combined Qualified Business Income Amount” – Including REIT Dividends. The Conference Agreement would create a new deduction for individuals, estates, and trusts of generally the lesser of 20 percent of their combined qualified income amount (CQBIA) or 20 percent of the taxpayer's income (reduced by any net capital gain). CQBIA is defined as the sum of qualified REIT dividends (QRDs), qualified publicly traded partnership income (QPTPI), and qualified business income with respect to a qualified trade or business of a partnership, S corporation or sole proprietorship (QBI).

For taxpayers above certain income thresholds ($157,500 for single taxpayers/$315,000 for married filing jointly), income from specified service business would be ineligible for inclusion in QBI. Similarly, for taxpayers with taxable income above these thresholds, the QBI calculation would be subject to a limit of the greater of: a) 50 percent of the taxpayer’s allocable share of the pass-through entity’s W-2 wages, or, b) 25 percent of the taxpayer’s allocable share of the pass-through entity’s W-2 wages, plus 2.5 percent of the unadjusted basis (for real property structures, but not land), immediately after acquisition, of all depreciable property used for the production of qualified business income by the qualified trade or business. REIT dividends are not subject to either of these limits.

In sum, a taxpayer qualifying for the full deduction would be subject to a maximum tax rate of 29.6 percent (33.4 percent with the ACA surtax).

This deduction would be applicable for taxable years beginning after Dec. 31, 2017, but would expire after 2025.

This claim from NAREIT might be true. If so, then 20% of ordinary REIT dividends (called "Qualified REIT dividends" in the new tax law) will be tax deductible starting in 2018. That would make REIT dividends clear winners over their C-corp counterparts in every case. However, the text of the TCJA Bill and the resulting Tax Code Section 199A are much less clear about this issue than the NAREIT interpretation. The government texts are convoluted. Poor grammar makes the tax code open to interpretation. There is a statement that qualified REIT dividends—what I’ve been calling ordinary REIT dividends—are included in the 20% pass-through entity tax deduction. What is unstated is whether qualified REIT dividends are subject to income limitations. I find it strange that complex income limitations were placed on all other pass-through income, but somehow qualified REIT dividends were spared from the limitations. After all, there was never any discussion or argument for this deduction prior to the passage of the bill—except on SeekingAlpha--another article by Dane Bowler and one by John Engle. Even prominent proponents of the bill, such as the Tax Foundation, still do not mention the qualified REIT dividend deduction. One would think that many REIT CEOs would want to promote this lucrative deduction to boost their lagging stock prices. But they haven’t which makes me think that they are unsure how the deduction will work.

Summary

Ordinary dividends from REITs and BDCs are competitive with C-corp dividends and capital gains. At many individual tax brackets, even the most heavily taxed REIT or BDC dividends are taxed at a much lower overall rate than C-corp investment income, plus they are never significantly higher than C-corp investment income. The other conclusion is that corporate taxes significantly reduce investment returns, but the new tax law lessens this effect. Investors often ignore C-corp taxes because they are taken before the investor ever sees the income, but they change a stock's performance. One final point that I would like to make is that C-corps can make excellent investments, but this article should be proof that investors do not need to avoid REITs or BDCs due to their tax characteristics.

If you enjoyed this article, then please see my other articles for a few REIT investment ideas.

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(UNIT) Uniti Group: Dark Fiber Lights The Way In Legal Abyss

Disclosure: I am/we are long CORR, HTGC, CLDT, KIM, MAIN, MPW, NEWT, NMFC, OHI, SBRA, SKT, STAG, TCPC, UNIT, VTR, WPC. 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.

Additional disclosure: My writings are not investing or financial advice. The contents of this article are my own research, which I have chosen to share with the investing community. All investors are obligated to perform their own analysis and to make their own investing decisions.