Why Get Taxed Twice? - Weekend Wisdom

Taxes might be the price we pay for living in a civilized society, but who wants to pay them? Let alone pay them twice???

Gladly, there are investments that only get taxed once. Better yet, they offer tax advantages that go beyond just the low rate on dividends and capital gains.

In this article I will tell you about three types of investments that will provide a very high and growing stream of income that is taxed only once. Thus, leaving more money in your wallet at the end of the day.

Why is There Double Taxation in the First Place?

One of the key reasons for having a lower tax rate on Capital Gains and Dividends is the issue of double taxation. On paper, the U.S. has one of the highest corporate tax rates in the world for ordinary stocks. In practice, given a multitude of exemptions, preferences and deductions, the effective tax rate is not particularly onerous. Then those dollars that have already been taxed generally get taxed again when they are paid out in dividends.

Or if the company re-invests those dollars and the company grows, or the company buys back stock with the money so each shareholder owns a bigger piece of the pie and the stock price is higher as a result, the capital gains are taxed.

However, there are types of "stocks" that avoid this entirely. These companies are not taxed at all at the corporate level, but, in return, they have to pay out almost everything they earn to their "shareholders" each year. These tend to be very asset heavy types of businesses that throw off a lot of depreciation.

For income-oriented investors, the requirement that they pay out virtually everything they earn is a benefit. Typically, these "pass through" type investments have the highest yields around. There are three major types of these companies: Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs).


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Master Limited Partnerships (MLPs)

Most of these are found in the Energy sector, typically companies that own the pipelines and storage facilities. There are also some exploration and development companies that are organized this way, and those typically have long-lived reserves that can be tapped reliably with very little dry hole risk. In other words, they have more of a focus on development than exploration.

Typically, after a pipeline is fully depreciated for tax purposes, it still has a very long remaining useful life. It is just the income, after depreciation, which has to be paid out. Some very low asset intensity companies, which tend to throw off a lot of cash flow (such as asset management companies), are also organized this way.

The MLP Business Model

The pipeline business, particularly interstate pipelines, is tightly regulated, but that regulation is generally pretty friendly. They generally do not have any commodity price risk, as they operate on a toll road model. If you go over the George Washington bridge, it does not matter if you are driving a brand new BMW or a 10 year old Chevy, you pay the same at the toll booth. As for the tolls themselves, for interstate pipelines, the toll goes up each July 1st by the PPI plus 2.65%. This allows for very stable and growing cash flows.

MLPs and Taxes

MLPs usually specify the percentage of each distribution that is shielded from ordinary income taxes. That percentage may vary from distribution to distribution, depending on a variety of factors. MLPs mail individualized K-1 tax forms early each year that details the tax treatment of the prior year's payouts.

The part of a cash distribution that is not taxable must be subtracted from your original purchase price to compute your new cost basis. When you sell, some of your gain will be taxed at the lower capital gains rate, but the part of the gain that results from deductions, such as depreciation lowering your cost basis, will be taxed as ordinary income.

Real Estate Investment Trusts (REITs)

A REIT must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders. REITs must have at least 75% of its assets invested in real estate, mortgage loans, shares in other REITs, cash or government securities, and get at least 75% of its income from them.

Types of REITs

The conventional (equity) REITs tend to specialize in different types of real estate, some focusing on owning office buildings, some on regional malls and others on apartment buildings. Some have a regional focus, while others have nationwide portfolios. As with the pipelines, the useful life of a building can go on long after it is fully depreciated for tax purposes. For example, the Empire state Building was opened over 80 years ago, and was long since fully depreciated, but clearly still has a lot of value.

Given the diversity of REITs, it is possible to play being bullish on, for example, apartment buildings in the Northeast, and not have any exposure to shopping malls in the Southwest, or vice versa. Mortgage REITs age generally more risky, but some can have extremely high dividend yields.

Given the weak Real Estate market of the past few years, the amount of new construction has been extremely low. There is some evidence that the market is starting to turn around in many areas. This could present an interesting time to be in REITs as a result.

Business Development Companies (BDCs)

Regardless if you like Mitt Romney for President or not, you would probably like to be able to invest like he does. However, you generally have to be very wealthy to invest in a Venture Capital or a Leveraged Buyout fund. There is, however, a way around this. Business development companies, or BDCs.

These are regulated as investment companies under the 1940 act, sort of the way a mutual fund is. However they must distribute to stockholders at least 90% of their "investment company taxable income." In some ways, it's similar to REITs. Like REITs, BDCs are typically high yielding stocks.

Private Equity Investing for the Rest of Us

In some ways, BDCs resemble mortgage REITs, but they are not limited to real estate related collateral. Typically they will invest in small to mid size private companies, sometimes for mergers or expansion, other times to assist with a change of control situation. They tend to be able to charge a high interest rate, and get an equity kicker. In effect, this is what venture capital and LBO companies do, but the entry price is much lower, and you can get out when you want just by selling the shares. You are not locked in the way you are at many venture capital funds.

It is a way for the 99% to invest like the 1% do.

How to Get These Special Investments Working for You

This Thursday, we launched my new service, Zacks Income Plus Investor , which looks at not just regular high-dividend stocks, but also vehicles like MLPs, REITs and BDCs. The goal is to balance more aggressive holdings by generating a steady, low-risk flow of income.

With long-term stocks projected to pay high dividends well into the future and other tax-advantaged investments, we should be able to create a portfolio generating twice the income of either the 10-year T-note or the S&P 500 as a whole.

If this sounds interesting to you, then view our video briefing which gives details including three moves I'm looking into. There's a substantial Charter Member savings that ends soon, so I suggest you check out Income Plus now.

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Good Investing,


Dirk van Dijk is Zacks' Chief Equity Strategist and a frequent contributor to CNBC, Fox Business and Bloomberg TV. He directs the new Zacks Income Plus Investor.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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