When investing in Real Estate Investment Trusts (REITs) or
Master Limited Partnerships (MLPs), investors are sometimes
surprised by the hefty tax bill. REITs and MLPs are taxed at
ordinary income tax rates if they are in taxable accounts, which
takes a big bite out of the total return for many. But there is a
way to get around this tax bill if an investor has capital losses
he can use. I call this strategy dividends to capital gains
The idea is this: By taking dividends in the form of capital
gains, and then offsetting those gains with capital losses you may
have, you can pay an effective tax rate of 0%. Compare this to
paying either the 15% rate for qualified dividends (for most
people) or your top marginal income tax rate on REIT investments
So how does one go about converting dividends to capital gains?
It takes some monitoring, but it could very well be worth your
time. First let's define the ex-dividend date for a stock:
The ex-dividend date is the day on which all shares bought and
sold no longer come attached with the right to be paid the most
recently declared dividend. This is an important date for any
company that has many stockholders, including those that trade on
exchanges, as it makes reconciliation of who is to be paid the
dividend easier. It is just as important for investors, however,
since you must own a stock before the ex-dividend date in order to
receive the next scheduled dividend.
If an investor buys the stock on the ex-dividend date or after,
he is not entitled to the next dividend. This also means that if an
investor sells the day before the ex-dividend date, he is not
entitled to the next dividend.
Given this, an investor can buy a stock the day of the
ex-dividend date and sell the day before the next ex-dividend date,
and be assured that he will never receive a dividend. Some might be
saying, what a horrible deal! But Mr. Market is no dummy. Those who
buy on the ex-dividend date and sell the day before the next one
will benefit from the stock price climbing by the amount of the
dividend during this time. If you ever notice why a stock's price
drops the eve of the ex-dividend date, this is because those buying
it on that day will not receive the next dividend. In fact, the
price drops by the amount of the next dividend. Conversely, the
stock price will begin climbing the day after the ex-dividend date
and will eventually rise by the amount of the dividend. Of course,
the price will fluctuate due to other variables, but the amount of
the next dividend is always embedded in the price.
Hopefully this all makes sense because for stocks with high
dividend yields, this strategy could provide a huge gain for
investors. Let's take a look at how this strategy might be used
with American Capital Agency Corp. (
), which has a dividend yield today of 19.3%.
Every quarter if I buy AGNC on the ex-dividend date and then
sell it the day before the next ex-dividend date. I pay no taxes
whatsoever on this dividend, yet receive all of the dividend yield
in the form of capital gains. I avoid taxes by offsetting the gains
with capital losses. This is a huge benefit to me because AGNC is a
REIT and investors must pay the full income tax rate on any
dividends that are paid.
Let's look at an example using AGNC where an investor buys 1,000
shares of AGNC. The combined marginal federal and state tax rate
for him is 33%. He is able to offset all capital gains with capital
losses and pays $8 per trade. I ran the following using our
publicly available calculator called
Minimize Taxes by Trading Dividends for Capital
and readers are free to run their own scenarios as well.
I will have accumulated over $68,834 more using this strategy.
That is a cumulative return that is 237% higher than if I just
collected the dividend. I can also adjust the amount of the capital
gains that I can offset. Let's say I can AGNC offset 50% of the
gains. Doing this still gives me a higher cumulative return of 373%
vs. 230% when not using this strategy.
Other REITs where this strategy would work well are Annaly
Capital Management (
), New York Mortgage Trust (
), Dynex Capital (
), Anworth Mortgage Asset Corp (
), Hatteras Financial (HTS), and Senior Housing Property Trusts
Because of the monitoring involved and the trading costs, this
idea is best suited for those stocks with relatively high
dividends. In the example above, if the dividend yield were below
2%, this strategy does not even pay off any more. But for REITs,
MLPs, and other high yielding stocks, especially those where
dividends are taxed at your income tax rate, this strategy will be
a sure-fire winner.
I am long [[NLY]].
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