Two of my favorite real estate investment trusts (REITs), Digital Realty Trust (NYSE: DLR), a technology real estate REIT, and Gladstone Capital Corp. (NASDAQ: GOOD), a commercial real estate REIT, are superior income investments: Digital yields 5%, Gladstone yield 8.4%.
Both also offer dividends that allow investors to manage their tax liability.
With most companies, the dividend is fully taxable to the investor (if held outside a retirement account).
[ad#Google Adsense 336×280-IA]Depending on your holding period (less or more than a year), the dividend will be taxed at either your marginal tax rate or the special dividend-tax rate.
For most investors, the rate is 15% or 20%, depending on the marginal income tax rate.
But with REITs like Digital Realty and Gladstone Capital, calculating taxes on dividends is less straightforward.
REIT dividends not only differ from C-corporation dividends – those issued from companies like ExxonMobil (NYSE: XOM), Microsoft (NASDAQ: MSFT), Wal-Mart (NYSE: WMT), etc. – they differ from REIT to REIT.
REIT dividends are really a mixture of earnings, return of capital, and capital gains. All three of these components are taxed at different rates, with return of capital not being taxed at all. Return of capital, instead, reduces the cost basis of the REIT investment.
For each REIT, the proportion of ordinary income, capital gain, and return of capital is unique.
For example, in 2013, Digital Realty paid $3.67 in per-share dividend. Of this dividend, $2.75 was ordinary income, while $0.92 was a capital gains distribution. This means $2.75 was taxed at the investor’s marginal income tax rate, while $0.92 was taxed at the capital gains rate –15% for most investors.
But this distribution between ordinary income, capital gains, and return on capital isn’t set in stone; it changes year to year.
In 2012, Digital Realty paid $2.83 in dividends per share. Of this amount, $2.58 was ordinary income, $0.02 was a capital-gain distribution, and $0.23 was a non-taxable return of capital. The key takeaway is that the full amount of the dividend is unlikely to be taxed at your marginal income tax rate.
In contrast to Digital Realty’s dividend, hardly any of Gladstone Commercial’s dividend is subject to immediate tax. In 2013, Gladstone paid $1.50 in dividends per share. Of that dividend, 81.7% was non-taxable return of capital, which means only 18.3% of the dividend was subject to immediate income tax.
If you pay attention to the composition of a REIT’s dividend, you can manage your tax liability by the type of REITs you buy: With a REIT like Gladstone, investors get use of 81.7% of the cash received, or $1.225. Immediate income tax needs to be paid on only 18.3%, or $0.275, of the 2013 dividend.
With Digital Realty, investors do pay more immediate income tax, but they’ll incur a lower tax liability when they sell their shares, because the cost basis hasn’t been reduced by return of capital.
Keep in mind, too, Digital Realty and Gladstone are dissimilar REITs. Digital Reality is a dividend-growth REIT. Investors should expect meaningful share-price appreciation with Digital Realty over time. Gladstone, in contrast, is a steady high-yield REIT, which tends to offer much less price appreciation but higher current yield.
More tax, more growth; less tax, more yield? You make the call by the REIT you choose.
— Steve Mauzy
[ad#wyatt-income]
Source: Wyatt Investment Research