3 tax smart alternatives

3 tax smart alternatives

Strategies with inherent tax efficiencies may help investors diversify sources of income and potentially keep more of what they earn.

KEY TAKEAWAYS

 

  • REITs offer three flavors of tax-advantaged income
    REITs have a history of attractive distributions before and after taxes, benefiting from a 20% tax deduction on REIT income and favorable tax treatment of capital gains and return of capital.
  • Preferred securities offer high current income with QDI benefits
    Preferreds tend to pay high income rates due to subordination, with most distributions treated as dividends rather than interest, taxed at a top rate of 20%.
  • A blended portfolio of tax-smart asset classes can be attractive
    We offer a strategy that blends preferred securities and REITs, along with infrastructure stocks, that can potentially provide high income with tax advantages while taking a more diversified approach than individual asset classes

Introduction

Investment solutions for a yield-constrained market

Historically low bond yields are driving a search for income to meet investors’ needs. At the same time, taxes have become a greater focus, especially with a unified Democratic government indicating a desire to raise tax rates on high earners.

Cohen & Steers provides access to specialized asset classes that offer the potential for attractive income, with inherent tax advantages to help investors keep more of the income they earn—both today and under any changes in tax policy that could occur in the next few years.

REITs

  • Designed for efficient delivery of rental income to investors, taxed only once (at the shareholder level)
  • 20% deduction on ordinary income distributions from REITs as qualified business income (QBI), reducing the top tax rate from 37% to 29.6%(1)
  • Three “flavors” of tax-advantaged income: QBI, capital gains and return of capital

Preferred Securities

  • Historically offer some of the highest income rates within investment-grade fixed income, from generally high-quality issuers
  • Distributions mostly treated as qualified dividend income (QDI) rather than interest, taxed at a top rate of 20% vs. 37%(1)
  • A wide range of security structures, including many with low durations, that may reduce sensitivity to changing interest rates
REITs and preferred securities answer the call for attractive, tax-efficient income
Types of income

REITs offer three flavors of tax-advantaged income

Single taxation and a history of high dividends

U.S. REITs are required to distribute at least 90% of their taxable income to shareholders and are exempt from paying corporate taxes if they distribute 100% of their taxable income. This single taxation and distribution requirement is why REITs have historically paid higher dividends than most other companies.

REIT income distributions get a 20% tax break

REIT income is generated mostly from property rents and historically makes up about 60% of overall U.S. REIT distributions. The income is considered qualified business income (QBI) and is entitled to a 20% deduction. This means that for every dollar of income, investors pay tax on only 80 cents of income, reducing the top tax rate from 37% to 29.6%.

Complementary tax-efficient income streams

In addition to QBI, REITs typically distribute the net gains from property sales as capital gains, taxed mostly at a top rate of 20%, while a portion is taxed at a top rate of 25%. Most REITs pay out all their net operating income to shareholders. However, they generally claim investment-related non-cash expenses, such as depreciation and amortization on their real estate assets, which reduces their taxable income. This difference in a REIT’s distributions between net operating and taxable income is considered return of capital (ROC). Any tax liability from ROC is deferred until the time of sale, when it lowers the investor’s cost basis in the investment.

EXHIBIT 1
REIT dividends have been tied to underlying cash flows

Aggregate taxation of REIT common share dividends

Aggregate taxation of REIT common share dividends
EXHIBIT 2
REITs maintain their tax-advantaged status with high payouts

% Current yield

Current yield

Potential impact of proposed policy changes on REITs

REITs likely to benefit from stimulus. We believe the vast amount of stimulus President Biden has implemented or is still seeking stands to benefit economic growth and, by extension, real estate demand. Stimulus can provide a lift for the economy, small businesses and consumers, and potentially benefit a range of REIT sectors, particularly industrial, retail and self storage. Infrastructure spending, meanwhile, could have a meaningful impact on demand for most property types.

Higher corporate taxes a non-event. Just as lower corporate tax rates in 2017 had no impact on REITs (which are not subject to taxes), higher corporate rates would likely have little or no effect on the asset class.

Increased individual tax rates would be modestly negative. REIT shareholders pay taxes on income distributions according to their individual tax rate, which at some point could rise for top earners to 39.6% from 37% based on Biden administration tax-hike proposals (withdrawn for now).

Additionally, the 20% pass-through deduction on QBI, which applies to REIT dividend income, could be adjusted to create parity with a higher corporate tax rate, and could be modified or eliminated for high-income taxpayers.

“Like-kind” tax exchanges may be eliminated. Should real estate investors no longer be allowed to defer capital gains if proceeds of property sales are reinvested in other assets, it could negatively impact transaction volumes, reducing REITs’ ability to improve their portfolios. However, we expect significant pushback from industry groups on such a proposal, and previous attempts have been unsuccessful.

Example of REIT ROC
Example of REIT ROC

Preferred securities offer high current income potential with QDI benefits, including low-duration preferreds with less rate risk

High, tax-advantaged income

Preferred securities are issued mostly by high-quality issuers, but due to their subordinated position in the capital structure, they often pay higher income rates than similarly rated bonds. Many of these distributions are classified as qualified dividend income (QDI) and taxed at a top rate of 20%, compared to 37% for ordinary interest income (plus a 3.8% Medicare surcharge). This combination of high coupons and tax-advantaged treatment creates the potential for attractive after-tax income relative to other fixed income categories. It also makes preferreds a compelling complement to municipal bonds.

Using current index yields as proxies, a hypothetical $1 million investment in preferreds would potentially generate $49,000 per year in pre-tax income. Assuming that 65% of the income generated is QDI eligible, that translates to $31,300 per year after taxes for investors in the top tax bracket—saving $5,400 in taxes, compared to the same income fully treated as interest.

Preferreds offer higher yields than comparable fixed income categories, along with the potential for reduced interest-rate risk
Low-duration preferreds may help to negotiate interest-rate cycles

Demand for low-duration fixed income has been growing as investors increasingly anticipate an end to years of near-zero interest rates. Preferred securities are an often-overlooked category in the low-duration universe. Yet the after-tax yield for low-duration preferreds compares favorably to most other investment-grade fixed income securities, including municipal bonds.

The fixed-to-floating rate structures of many preferreds typically reset with changes in short-term rates, mitigating investors’ exposure to changes in interest rates. Thanks to these reset structures, more than 75% of the preferred market has durations under five years. Low-duration preferreds also typically represent different sectors than what investors get from other low-duration fixed income securities, helping to diversify investors’ portfolios.

The current relative yield advantage of preferreds partly reflects ample QDI available in the asset class
EXHIBIT 3
Preferreds’ combination of high coupons and favorable tax treatment offers the potential for attractive after-tax income

% Yield to maturity

Yield to maturity

Alternative income investing

The investment universe of real asset and alternative income securities has expanded significantly over the past several years. As one of the few specialist investment firms focused on the space, Cohen & Steers offers an Alternative Income Strategy that seeks to enhance and diversify income. The Strategy targets three non-traditional sources of income in a unified portfolio offering the potential for three benefits:

  1. High, tax-advantaged income. The alternative income assets in the strategy provide tax-advantaged distributions including QDI, QBI and ROC. Exhibit 4 below highlights the potential income advantage of an alternative income blend, both before and after taxes, compared with more traditional stocks and bonds.
  2. Lower volatility. Because these alternative asset class exhibit low historical correlations to one another, a blended allocation can provide a potentially smoother investment experience than investing in them separately. This helps avoid the emotion often tied to higher levels of short-term volatility, particularly for investors who may be unfamiliar with alternative investments.
  3. Low sensitivity to traditional assets. The strategy may help strengthen portfolio diversification. An alternative income blend has historically exhibited a low sensitivity to both traditional stocks and bonds. This may help enhance a portfolio’s overall risk-adjusted returns in the long term.

Three asset classes, one 1099. In addition, a consolidated alternative income strategy can deliver convenience benefits. We offer an open-end vehicle— Cohen & Steers Alternative Income Fund—that provides investors a simplified way to seek tax-advantaged and above-average income streams. These non- traditional asset classes are unified under one NAV, and investors receive one 1099 at tax time.(1)

EXHIBIT 4
Alternative income offers attractive income from tax-advantaged asset classes

Many alternative income assets provide tax benefits

Alternative income offers attractive income from tax-advantaged asset classes

Conclusion

Asset classes with inherent tax efficiencies, such as REITs and preferred securities, have the potential to produce higher-than-average income and returns compared to the broad equities market and traditional fixed income securities, respectively. They can also expand portfolio diversification to help enhance overall risk-adjusted return potential, thereby complementing investments such as municipal bonds in tax-efficient allocations for high after-tax income.

Cohen & Steers is a leading specialist in listed real assets and alternative income solutions, with a long track record of strong investment performance and an experienced, global team focused on delivering results for our clients. Contact your investment professional today to learn more about tax-smart income solutions from Cohen & Steers.

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