As we await the much anticipated tax reform changes supposedly going to the President’s desk before Christmas, we have no choice but to try, as futile as it might end up being, using the last three to four weeks of the year on tax planning. One area of the tax code sure to change is the treatment of dividends which in the case of REITs, may be affected by both changes in ordinary income tax rates as well as capital gains rates.
You might be wondering how a change in capital gains tax rates could affect dividend income right? At least if your holdings aren't held in a qualified retirement account.
Well, because of the REIT structure and its requirement to pay out 90% of its taxable income, REIT dividends are further classified into several categories and this breakdown has tax implications for shareholders.
Realty Income’s (O) dividend distribution categories are shown below for its fiscal year 2016. Notice that of the $2.39 dividends paid in 2016, $1.88 was considered ordinary income while $0.51 was nontaxable distributions. Before you go jumping for joy, let me explain the implications of the nontaxable distributions.
While you may not have had to pay taxes on these distributions in 2016, what a nontaxable distribution does is reduce your cost basis. That is because it is considered a return of capital. So in the example below, if you paid $50 for a share of Realty Income, your cost basis is now $49.49. This is important, particularly for investors who have held the stock for a long time, because it has huge implications for capital gains when the stock is sold. The problem is that your statement probably reflects the price you actually paid for the stock and the unrealized gain it is showing may be understated. Only by looking at your 1099-DIV for each year you held the stock can you determine what your true capital gain will be when you sell the stock.
So as you approach the end of the year and you are working with your advisor on tax loss harvesting, you may look to some of your dividend paying REITs to look for offsetting gains that may not be apparent on the surface – at least not on your statement.
Another REIT, which we are currently analyzing for inclusion into the REIT portfolio is Independence Realty Trust (IRT). The breakdown of its dividend payments is shown below and is quite different from the Realty Income breakdown shown above.
The majority of IRT’s dividend distributions were treated as capital gains, which means shareholders would have to pay a capital gain tax on that portion of the dividends received while they held the stock. Unfortunately, while most of the time shareholders control the sale of a stock and hence, when a capital gain is realized – that is not the case with REITs.
The other category shown below which is not shown in the Realty Income breakdown is Unrecaptured Section 1250 gain. This gain is realized on the sale of depreciable real estate and is a type of depreciation recapture. For shareholders, it is also treated as a capital gain so it too can be used to offset capital losses.
So as you’re contemplating portfolio rebalancing keep in mind that the cost basis shown on your statement may not be the accurate price to use to calculate capital gains on a particular position and – as is the case with IRT – the dividend income received in a particular year may not all flow to ordinary income.
Make sure you consult with your tax advisor and financial advisor so any tax minimization strategy calculations being made are taking the above categorization of dividends into consideration.
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Disclosure: I am/we are long O.