Tax-smart income alternatives

Tax-smart income alternatives

17 minute read

March 2024

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

KEY TAKEAWAYS

  • Income-efficient asset classes can offer solutions for tax-conscious investors
  • REITs offer three aspects of tax-advantaged income
  • Preferred securities offer high current income with qualified dividend income (QDI) benefits

Introduction

As investors consider solutions to their income needs, identifying asset classes that offer tax advantages can be a powerful part of the equation.

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 aspects 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
Types of income
Types of income

REITs offer three aspects of tax-advantaged income

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 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%.

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

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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

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 $66,000 per year in pre-tax income. Assuming that 65% of the income generated is QDI eligible, that translates to $46,700 per year after taxes for investors in the top tax bracket—saving $7,300 in taxes, compared to the same income fully treated as interest.

Recent rate increases in money markets and short-term Treasurys have drawn interest from investors, many of whom fail to anticipate the taxable nature of that income. Short-duration preferreds, while not a cash equivalent, are often thought of as a conservative step into the low-duration market with tax advantaged benefits.

Beyond that, 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.

EXHIBIT 3
Preferreds can offer tax-advantaged income for U.S. investors

Fixed income yields(1)

Preferreds can offer tax-advantaged income for U.S. investors

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.

FURTHER READING

Three reasons to own REITs today

3 Reasons to own listed REITs today

April 2024 | 6 mins

We see compelling evidence to own listed real estate in the current environment.

3 Reasons to own preferred securities today

3 Reasons to own preferred securities today

April 2024 | 5 mins

We believe an exceptional buying opportunity for preferred securities may exist today.

Understanding quality, ratings and long-term compensation of preferred securities

Understanding quality, ratings and long-term compensation of preferred securities

March 2024 | 38 mins

Preferreds provide attractive income and total returns from high-quality securities; despite added risks, default rates can be lower than credit ratings suggest.

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