Sometimes you’re better off owning individual stocks than owning a fund.
Bad news for people who own the Vanguard Real Estate Index Fund and other funds like it: The hastily drafted tax cut has a mistake in it. The tax writers neglected to let funds pass through to their investors the tax goodie given to real estate investment trusts.
There’s a cure. Don’t own a Reit fund. Own Reit stocks instead.
This essay will explore Reit economics, Reit taxes and the legislative problem. I’m bullish on the sector, which has fared poorly in the current bull market and is overdue for some catching up. But don’t buy without thinking of your tax bill. If you want real estate exposure in a taxable account, a fund is an inefficient way to get it.
Real estate investment trusts are a big business, with $1 trillion of shares outstanding. Almost all of them are the equity type, meaning they own assets like buildings, cell towers, data centers and trees. The other kind, mortgage Reits, own IOUs. Here, we will be looking only at equity Reits.
This is a good time to be buying real estate shares. They have been lagging as yield-conscious investors fret about rising interest rates. But think about why interest rates are rising. Isn’t it mostly because inflation is coming back? And isn’t rising inflation a reason to own more, rather than less, real estate? Rents keep up with the cost of living.
The tax goodie: a 20% deduction from a Reit’s ordinary income, which is the landlord’s profit from renting. The Reit deduction resembles the one granted to businesses taxed as partnerships, but it doesn’t have the business-deduction’s restrictions (which relate to wages and depreciation).
Example: Simon Property Group (SPG), the Indianapolis-based mall operator. It’s on target to pay out $7.80 a share this year, for a 5% yield on the recent $156 share price. Some portion of this cash, perhaps 40 cents, will be a qualified dividend eligible for the 0%/15%/20% rate schedule. (You get qual-div income from a Reit when it has a subsidiary paying corporate tax.) The balance of the SPG dividend, $7.40 or so, should be eligible for the 20% freebie. Congress wants you to have $1.48 of tax-free income from this share of stock.
Unless, it seems, you own Reits via the Vanguard Real Estate Index Fund (VNQ), where SPG is the largest holding. The December tax redo by Congress neglected to include a rule allowing investment companies to pass the 20% Reit deduction along to their shareholders.
That is the reading of the messy law given to me by one tax expert. His view is seconded in published commentary coming from accounting firm Ernst & Young, law firm Wilkie Farr and real estate money manager Cohen & Steers. From Vanguard: “The fund industry is currently working through its trade groups to obtain regulatory guidance on this issue.”
If you want to put your real estate shares in an IRA, a fund is a fine way to amass them. Taxability of dividends is irrelevant inside a tax shelter. But if you want to own this sector in your taxable account, you’re likely to do better with do-it-yourself money management than with a fund. You won’t be cheated out of the 20% deduction.
Might Congress correct its mistake? It might. In normal times a clean-up technical corrections bill follows a big piece of legislation without much controversy. But nowadays there’s enough partisan rancor to make easy corrections difficult.
The Republicans might try to buy enough Democratic support to get the 60 Senate votes they need to push a corrective tax bill through. Alternatively, they could put a sunset on the bill so that it can be enacted with a simple majority, just as the tax cut was enacted.
But they might do neither of those things. They might let the repair work slide until after the election. And then anything could happen. It’s possible that fund investors will never see that 20% deduction.
If you are investing in a taxable account, home-brewing your own real estate fund will increase your risk (you’ll be less diversified), but it will also increase your expected aftertax return. You will benefit from:
--the 20% Reit deduction. How much this is worth depends on what you own and where you live, but 28 basis points (0.28% of assets annually) is a good estimate.
--eliminating the ETF fee of 7 to 12 basis points.
--getting an opportunity to selectively harvest losses from individual stocks, as opposed to taking a loss on an ETF. If a sector is flat to slightly up over the next several years, a diversified ETF will have no capital loss to be captured, even as some individual stocks inside it will have losses.
It’s not easy to put a precise value on the opportunity to do fine-grained loss harvesting. But note that loss-harvesting services working on the entire S&P 500, one stock at a time, aim to deliver tax benefits worth 100 basis points or so. Some portion of this, perhaps 10 or 20 basis points, comes from being able to pluck out individual stocks for loss taking, as opposed to selling an entire sector when it’s down.
The table displays an assortment of Reits owning different flavors of real estate. I exclude timber Reits here because they won’t benefit from the 20% deduction. (There are other reasons to own timber stocks, explored here.)
With Reits you have, as with any investment, a trade-off between current yield and prospects for growth. Equinix (EQIX), a global chain of data centers, and American Tower (AMT), which owns cell towers, pay a modest dividend but are likely to grow. Welltower (HCN), which supplies capital for medical offices and senior housing, presents a reverse picture.
I explain loss harvesting in Tax Stratagem For A Volatile Market.
