Key Points
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Mortgage REITs and business development companies tend to have very large yields.
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Mortgage REIT and BDC dividends are generally treated as regular income and taxed at your normal tax rate.
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If you own Mortgage REITs and BDCs in the right account, you can avoid paying taxes on the income they generate.
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Investing is about more than just picking good stocks and bonds and holding them for the long term. You should also consider the tax implications of the investments you make. The easiest example of this is the bond space, with the dichotomy between corporate and municipal bonds. Corporate bonds are fully taxable, but muni bonds can help you avoid paying taxes on the income they generate.
But there’s another level to the issue, because certain retirement accounts also allow you to avoid taxation. Investors in ultra-high-yield mortgage real estate investment trusts (REITs) and business development companies (BDCs) need to pay close attention to where they place these securities. Here’s where they probably belong, if you want to minimize your tax hit.
You need to pay your taxes, but you don’t want to pay too much
The taxes you pay help to pay for all of the government services that you receive. That includes something as simple as having a road to drive your car on, to more complex things like paying your state representatives. For the most part, these are good things, and you should pay your taxes. If you don’t, the government will eventually come calling. You don’t want that to happen.
That said, the tax code is mind-boggling complex. The simple logic is that if you earn income, you have to pay some tax on that income. That’s easy enough if the income you earn comes from a job. It is more complex if the income is generated from investments you own. Dividends, as it were, are not all created equally.
This is particularly important for real estate investment trusts and business development companies. Both of these corporate structures are designed to pass income on to shareholders in a tax-advantaged manner. So long as REITs and BDCs pass at least 90% of their taxable income on to shareholders as dividends, they do not pay corporate income tax. The shareholder pays taxes on that dividend income, which is taxed at the same rate as earned income. There are nuances here, but that’s the big picture you need to keep in mind.
What’s AGNC’s 13% yield doing to your taxes?
AGNC Investment (NASDAQ: AGNC), a well-respected mortgage REIT, has a 13.5% dividend yield as of this writing. Annaly Capital (NYSE: NLY), another mREIT, yields roughly 12.5%. Main Street Capital (NYSE: MAIN), a highly respected BDC, has a yield of 5.5%, which rises to around 7.5% if you include its special dividends. And Ares Capital Management (NASDAQ: ARCC), one of the largest BDCs you can buy, has a yield of 9.5%.
The main reason to own all of these stocks is to maximize the income you generate. But, because they are REITs and BDCs, most of that income will get taxed at your normal tax rate. If you aren’t prepared for that, you could be in for a surprise come April 15. There’s a solution thanks to the quirks of the tax code.
Roth IRAs and Roth 401(k)s are funded with after-tax money. Because you have already paid taxes on the money in the account, the money you withdraw is tax-free. So, if you buy a BDC or REIT (including mREITs) inside of a Roth IRA or Roth 401(k), you effectively take income that would be taxed at a high rate and turn it into tax-free income.
It matters where you own your stocks for tax purposes
Let’s say you own a bank with a 5.5% yield (that’s kind of high for a bank right now, but go with it) and you also own Main Street Capital, which has a 5.5% yield (excluding the impact of special dividends). Bank dividends are generally treated as dividend income, which is treated more favorably tax-wise than earned income. Main Street’s dividends will be treated as earned income. If you can put one of them in a Roth account, you’ll be better off tax-wise if you put Main Street (or any other BDC or REIT) into the Roth.
In truth, this isn’t a huge deal for your investment portfolio. It is just a matter of putting certain investments in certain accounts. But if you don’t know, it can be a big deal for your taxes. Now that you do know, however, you may want to reconsider your portfolio, strategically placing dividend stocks where their dividends are subject to the most favorable tax treatment. You certainly shouldn’t violate any tax laws, but you should use the favorable rules that exist to the fullest possible extent.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.