Since starting this project, I have seen a lot of recommendations that suggest I should be holding my medical office building portfolio in tax-advantaged accounts. The concern is that because REITs generate so much income from dividends, my Uncle Sam will take a lot of that income before it ever reaches my pocket.
So, I took a long hard look at how my medical office building REIT dividends are taxed. To accomplish this, I purposely generated about $100 in dividend income from my stake in Physicians Realty Trust (DOC). This hundred bucks hit my brokerage account in mid-October of 2019. Up until then, I was following the herd and keeping most of these assets in my retirement accounts so I wouldn’t need to worry about taxes.
435 shares X $0.23 dividend per share = $100.05
As you might remember, we already know I paid about $8.00 of this to the federal government for the $44 non-qualified portion of the dividend.
Through that exercise, we found out that the non-qualified dividends paid out from my healthcare REITs are taxed just like regular income. That’s not ideal. We call non-qualified REIT dividends “Section 199A” dividends. They hit my regular tax bucket just like all my other regular income does. For Mrs. Max OOP and I, that comes out to about 22 cents on the dollar. That’s because we land in the 22% tax bucket. For tax purposes, we would much rather see qualified dividends because they are taxed at the more favorable long-term capital gains rate of 15%. That’s a 7% spread and comes out to $70.00 for every $1,000 in taxable income.
As it turned out, only about $44.00 of the $100 was considered non-qualified dividends. I even got a deduction to lower the $44.00 in taxable income even more. At the end of the day, I only paid $8.00 in tax on my $44.00 non-qualified dividends. That came in at 8%.
But what about the other $56 in non-dividend distributions?
Here is a look at my non-dividend distributions directly from my tax form:
The $56 distribution represents the “return of capital”. In theory, I am getting some of my original investment back. The non-dividend distribution is the depreciation deductions for the assets within the fund. In my case, the medical office buildings in the portfolio are depreciating and I get some of that back.*
The $56 did not hit my 2019 tax return and I was not taxed on it in 2019. The cash flow still hit my brokerage account, but I didn’t need to worry about the taxes.
I don’t get off scot-free, though. Eventually, a tax will be assessed. But not at the regular income tax rate.
How Does it Work?
As I mentioned, I needed to buy 435 shares of Physicians Realty Trust from August to September 2019 in order to generate the $100 in income. These are the specific shares of the company that generated the $100 in total dividends referenced above.
As you can see, my total cost for actually purchasing these 435 shares was about $7,642. This is considered my “cost-basis” and it is used for figuring out capital gain taxes should I ever sell the stock. That tax rate is between 0%-20% for long-term capital gains. For most people reading this, it is probably 15%.
Cost Basis = $7,642
The average cost basis on these 435 shares was $17.57 when I bought them.
$7,642 / 435 = $17.57 = average cost basis per share
But let’s say the value of my 435 share investment grew by $100 to $7,742. This would put the share price of DOC at about $17.80. If I decided to sell at that price my capital gains would be $100, right?
435 X $17.80 = $7,742
$7,742 – $7,642 (cost basis) = $100 capital gain
Wrong again, Max.
Chopping Away My Cost Basis
Because I was returned $56 in capital from the 435 shares in Q4 2019, my cost basis was reduced by $56. It is no longer $7,642.
$7,642 – $56 = $7,586 = new cost basis
So my capital gain on the investment if I were to sell at $17.80 is actually $156.
$7,742 sale price – $7,586 new cost basis = $156 = capital gain
When I go to sell Physicians Realty Trust, I now have $156 gain to deal with; $100 price appreciation and $56 non-dividend distribution.
$100 (true capital appreciation) + $56 (non-dividend distribution) = $156
Don’t take my word for it, here is a look at the actual shares:
Here is another way for me to demonstrate the same concept. See how much I paid for those shares on 9/30/2019? From below, you can see the cost basis on the transaction was $3,037.75. But from above, you can see the non-dividend distribution related to those shares reduced my cost basis on the same set of shares to $3,015.81.
What Does All of This Even Mean?
Clearly, REIT taxation is a complicated topic. However, so far I am not as scared of the income as I
once never was. In theory, a 15% long-term capital gain tax will eventually hit my $56 non-dividend distribution.
$56 X 15% = $8 capital gains tax
I was already taxed $8 in 2019 on my $44 nonqualified dividends. Now I am looking at another $8 tax on my future capital gain on the $56. We are up to a $16 tax on my $100 dividend.
$16 / $100 = 16% tax rate
As you can see, the non-qualified dividend tax and the future capital gain tax will come in at about $16, for a total of about 16%. This is much lower than the 22% I was thinking.
In short, the taxes on my non-dividend distributions are deferred until I sell the investment. They will be taxed at the long-term capital gain rate the year I sell the shares. For those of you out there interested in early retirement, I am starting to see a little strategy here, but we will have to cover that another time.
This got me wondering if there is a misconception about REITs. Are people just taking the easy way out and throwing them in their tax-advantaged accounts so they don’t have to worry about the tax details? For me, a 16% tax rate on my passive income seems reasonable. I don’t even have to pay Medicare FICA or Social Security FICA on it.
REIT taxes are tricky, so I will leave it at that so you can read through it a few times. I wrote this and even I had to read it a few times. In the meantime, I am planning on growing my brokerage REIT allocation as we move through 2020 so we can run through this calculation again in 2021 with some bigger numbers.
*If anyone has additional commentary on this, I would love to hear it in the comments.
Usual disclaimer, I am not a tax professional and this is not tax or investment advice. It is not a recommendation to buy anything and you are responsible for your investing decisions.
Just like the IRS does, I rounded the numbers above to the nearest dollar. For fun, I did the same calculation out to the decimal and came up with a total tax rate of 16.14%
The powers that be could always change the 0% – 20% long term capital gain tax rate. So just like any other responsible investor, I will keep an eye on those regulations.