The Surprising Tax Benefits of a Popular High-Yield Investment

Publicly traded real estate investment trusts (REITs) are as varied as the real estate they own.

You’ll find REITs that own commercial buildings, storage units, warehouses, retail centers, apartments, and even single-family homes. You’ll find financial REITs that own no real estate. They specialize in owning the property’s mortgage.

Income is the universal draw. Investors are drawn to REITs for their high-yield dividends. Dividend yields three, four, and five times the yield by many blue-chip stocks are on offer.

High-yield dividends are common knowledge. Composition of the dividend is less known. Most investors have no idea what constitutes the dividend they receive from their REITs.

Ignorance isn’t bliss. By failing to understand what constitutes the dividend, investors miss an opportunity to manage their income-tax liability.

Most dividends are fully taxable to the investor (if held outside a retirement account). Depending on your holding period (less or more than a year), the dividend will be taxed at either your marginal tax rate or the capital-gains rate — 15% or 23.8% for most investors.

With REITs, dividend taxes are less straightforward. REIT dividends differ not only from C-corporation dividends – issued by companies like ExxonMobil (NYSE: XOM), Microsoft (NASDAQ: MSFT), Walmart (NYSE: WMT), etc. – they differ from REIT to REIT.

Most corporate dividends are composed of earnings. REIT dividends, in contrast, are an amalgam of earnings, return of capital, and capital gains. All three of these components are taxed at different rates. Return of capital incurs no immediate tax liability. Instead, it reduces the investor’s cost basis.

Dividend Composition and Tax Consequences of Most REITs

Ordinary Income Capital Gain Return of Capital
Marginal Income Tax Rate 15%-23.8% for Most Investors Lowers Cost Basis

What’s more, composition of the three varies from REIT to REIT. Two of my favorite REITs serve as an example.

STORE Capital (NYSE: STOR) owns and leases single-tenant retail outlets. Gladstone Commercial Corp. (NASDAQ: GOOD) owns and leases commercial real estate. STOR Capital offers a 4.3% starting dividend yield. Gladstone Commercial offers a 7.6% starting dividend yield.

STORE Capital paid $1.18 in per-share dividends in 2017. Of this dividend, $0.99 was considered ordinary income. The remainder was a capital-gain distribution. This means $0.99 was taxed at the investor’s marginal income-tax rate, while $0.19 was taxed at the capital-gains rate – 15% for most investors.

In contrast to STORE Capital’s dividend, Gladstone Commercial’s dividend was subjected to lower immediate income tax.

Gladstone paid $1.50 in per-share dividends in 2017. Of that dividend, only 39.6% – $0.59 – was considered ordinary income. This means that only 39.6% of the dividend was subjected to immediate income tax.

The rest – $0.91 – was considered a return of capital, which has no immediate income liability. The cost basis is lowered by the amount of the capital returned.

If you pay attention to the composition of a REIT’s dividend, you can manage your tax liability by the REIT you buy. With a REIT like Gladstone Commercial, investors get full use of 60.4% of the cash received, or $0.91. Income tax needs to be paid on only $0.59 of the 2017 dividend.

Does Gladstone Capital’s higher dividend yield and lower immediate tax liability suggest it’s the better investment? Not necessarily.

STORE Capital investors pay more immediate income tax, but they’ll incur a lower tax liability when they sell their shares. The cost basis remains constant because no capital is returned.

STORE Capital and Gladstone Commercial are also dissimilar REITs. They focus on different market segments.

Dividend policy is another differentiator.

STORE Capital is a dividend-growth REIT. Investors should expect meaningful share-price appreciation over time.

Gladstone Commercial is a steady high-yield REIT. These REITs tend to offer much less price appreciation but higher immediate dividend yield.

More tax, more growth or less tax, more yield? You make the call with your REIT choice.

Published by Wyatt Investment Research at