An area of economics and investing that I find fascinating is the idea of unintended consequences. The government makes a change to policy or tax law to address a problem (or create an incentive) and they unintentionally cause other changes to made.
One example of this was noted in a recent post Trump is telling you to pay off your mortgage today. The gist of that article was that, as of 2017, both Trump and the Republicans who control Congress have put forward tax reform plans that call for a massive increase in the standard deduction. Their goal is to simplify the tax filing process. A higher standard deduction makes it more likely that the standard deduction is higher than itemized deductions. If you don’t itemize deductions then there’s no tax benefit to charitable deductions, the interest on your mortgage, etc.
In short, increasing the standard deduction will have the unintended consequence of making mortgage interest less likely to be deducted, which will likely reduce housing prices.
REITs, bonds, and tax rates
Lowering tax rates will have an unintended consequence on the valuation of REITs (Real Estate Investment Trusts) and bonds.
As you probably know, qualified dividends are taxed at special rates. When you get a $100 dividend check from Johnson & Johnson or Apple it is not taxed as normal income. Rather, it’s taxed at 0% to 20% depending on what tax bracket you’re in. The idea here is that the corporation has already paid corporate taxes on income before paying dividends, and it doesn’t make sense to then have shareholders pay full income tax on that same income.
REITs are a special type of business that does not pay taxes at the corporate level. Dividends from a REIT are taxed as normal income, which means they are taxed at rates from 10% to 39.6%. Income from REITs is subject to this higher rate because the income isn’t taxed at the corporate level.
Just like REITs, the interest from non-government bonds is considered taxable income and taxed at regular income rates. The higher taxes are one of the major disadvantages to investing in bonds.
This means that at every income level and tax bracket you will pay higher taxes on REIT/bond income than on qualified dividends.
TheMoneyCommando Real Tax Brackets
To properly compare the actual effective tax rates on income vs. dividends I’ve created something I humbly call “TheMoneyCommando Real Tax Brackets”.
Comparison of Tax Rates
|Tax rate on ordinary income||over||to||Tax rate on qualified dividends|
|Married filing jointly|
|Tax rate on ordinary income||over||to||Tax rate on qualified dividends|
Note that in this table I’ve included the effect of the personal exemption of $4,050 per person and the standard deduction of $6,300 per person. You get to reduce your taxable income by both the exemption and deduction (although this exemption is phased out around the end of the 33% bracket, which I’ve factored into the table above). This means that there is effectively a 0% bracket from $0 to the sum of the personal exemption and standard deduction, with the tax brackets all adjusted upward accordingly.
For example, the 10% tax bracket for single people actually goes from $0 to $9275, but you get to exempt the first $4,050 from taxes and then deduct $6,300 for the standard deduction (or deduct your itemized deductions if they are higher), for a total of $10,350 of exempted income. This means there is a 0% tax bracket for single filers that effectively goes from $0 to $10,350 and the 10% tax bracket for single filers actually goes from $10,350 to $19,625.
Including the personal exemption and the standard deduction, a single person pays no taxes on the first $48,000 of qualified dividends (assuming no other income). After that it’s 15% all the way up to $425,400.
Married couples pay no taxes on the first $96,000 of qualified dividends (again, assuming no other income) and then only 15% up to $487,650.
We can now use this table to property compare REIT/bond income with qualified dividend income.
Let’s compare the income from various sources. We’ll look at one of my favorite REITs (Omega Healthcare Investors – OHI), the benchmark rate on a 5-year A-rated corporate bond, and a dividend income stalwart (Coke – KO). For all of these comparisons we’ll assume you’re married filing jointly and you are currently making a combined $100,000/year.
I chose A rated bonds for this comparison because they have a small but non-zero default rate (.06% default rate average from 1981-2008, according to Wikipedia) with better returns than an AA or AAA rated bond.
As of March 24, 2017, here were the pre-tax yields for each investment:
- OHI: 7.44%
- 5yr A rated corporate bond: 2.21%
- KO: 3.33%.
We can then compare the after-tax yield for both investments (at today’s tax rates):
- OHI: 7.44% pre-tax yield – 25% income taxes = 5.58% after-tax yield
- 5yr bond: 2.21% pre-tax yield – 25% income taxes = 1.66% after-tax yield
- KO: 3.33% pre-tax yield – 15% tax on qualified dividends = 2.83% after-tax yield.
As you can see, even with higher taxes, the REIT still provides about double the return that the dividend stock does, and the A-rated bond provides about 59% the return with very little risk.
Effect of proposed tax changes
If the tax changes proposed by both the GOP Congress and President Trump are passed then REITs and bonds will become more attractive on a relative basis. This is because one of the proposed tax changes would tax all investment income at the same rate preferred rate.
REIT and interest income (bonds, CDs, etc.) and that is currently taxed as income would instead be taxed at the lower capital gains rate that qualified dividend stocks use. It’s also possible that the actual capital gains rates will be reduced as well, but since all investments will be taxed at the same rate the exact tax is not important.
Effect on prices
Let’s assume that the current ratio of after-tax income from OHI to KO is “correct”. That is, we assume an efficient market that is properly pricing both stocks. If the after-tax yield of OHI is 5.58% and the after-tax yield of KO is 2.83% then we can assume that the correct ratio between the two is 1.91:1. That is, the after-tax yield of OHI should be 91.1% higher than the after-tax yield of KO. A similar ratio should exist for bonds.
If a tax plan is passed that changes the tax rate on income from REITS and bonds from 25% to 15% for somebody making $100,000, here is what the after-tax yields would be:
- OHI: 7.44% – 15% taxes = 6.32%
- 5yr bond: 2.21% – 15% taxes = 1.88%
- KO: 3.33% – 15% taxes = 2.83% (unchanged)
The after-tax yield for OHI has gone from 5.58% to 6.32%, for a 13% increase. The after-tax yield on the bonds has also got up 13%, from 1.66% to 1.88%.
In order to keep the ratio between OHI and KO (and 5yr bonds and KO) the same, the prices of both OHI and bonds have to increase by about 13%.
In short, for this tax bracket, the proposed GOP tax changes would made REITs and bonds about 13% more valuable.
I wouldn’t recommend going out and buying a bunch of bonds or REITs based on this information. First, the defeat of the GOP’s healthcare proposal raises doubts about their ability to make large changes to tax law. It’s also entirely possible that the final tax changes won’t include the change in taxation of REITs and/or bonds.
However, you could do some basic probability analysis using the above information to inform a buy decision today. Let’s say that you think there’s about a 33% chance of this tax change being implemented. You’d multiply this probability of change by the value of the change and calculate that REITs/bonds are 33% * 13% = 4.33% more valuable than they are today. You can plug your own probability into the above calculation to get your own valuation estimate.
I wouldn’t recommend you convert your entire portfolio to bonds and REITs because of this information, but if you’re on the fence between 2 different kinds of investment, this information might help sway your decision.