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When you own over 250 medical office buildings (MOBs), it can be hard to find a place to put them all. What may seem like a daunting task to some, Max OOP always has a master plan. Like most other things here at Max Out of Pocket, we always keep optimization and simplicity at the forefront of every strategy we put in place.
If you need to catch up, Max OOP has slowly built up a healthcare REIT investment called Physicians Realty Trust (DOC) to just over $28,000. DOC primarily makes me money by owning and renting out medical office buildings to organizations that provide direct medical care. As of the beginning of August, this investment is projected to earn me about $1,500 in passive income over the next 12 months. This happens even while I am doing fun things like checking out the highest tides in the world or taking photos of lupines in northern New Hampshire.
We have not pulled the trigger on early retirement yet, so we spent some time a few weeks back busting tax brackets to make sure we understand how our income gets taxed. We found Mrs. Max OOP and I are still getting taxed about 22 cents on the dollar in federal income taxes for each additional taxable dollar we add to our income bucket. So we need to be really careful when we build a healthcare REIT money machine that spits out quarterly dividends on a conveyor belt right back into my pocket four times per year. We don’t have to worry about Medicare FICA or Social Security FICA at our income level since those taxes don’t apply to unearned income. But we do have to worry about regular federal income taxes. We don’t want the federal government reaching into my pocket and taking 22% of those ‘rental dividends’ since that can really hurt my ability to grow the portfolio and retire early. We would rather take that 22% and invest it for additional gains.
For the sake of simplicity, I was hoping we could just assume all of DOC’s dividends are what we like to call, ordinary dividends. But in reality, in 2018 only about 30% of the dividends Physicians Realty Trust released were considered ordinary dividends and the rest is what they call “non-dividend distributions”. We are going to dig into the difference between these in a later post, but for now, I am going to zero in on the fact that DOC’s dividends are both ordinary and a bit complex. As a general rule, usually Max OOP doesn’t like ordinary or complex, and that rule of thumb applies to these dividends.
The bad thing about ordinary dividends is they are taxed like ordinary income and land in the ordinary earned income federal tax buckets. I like to compare these ordinary dividends with earned income someone might earn from their regular day job. If the REIT dividend was a qualified dividend, it would be taxed at a much lower rate (0%, 15%, or 20%).
We won’t get too deep into the definition of a qualified dividend here, but generally, REIT dividends just don’t meet the IRS requirements to be considered a qualified dividend. That makes them non-qualified, or just ordinary dividends.
These ordinary dividends can become unfavorable if someone like Max OOP is still working and sitting in a higher tax bucket. In my case, the ordinary dividends put back into my pocket by DOC would be taxed at 22%. This is not ideal and can quickly turn my $1,500 in annual income into only $1,170 once I settle up with my Uncle Sam. That would be a sad story, so I am not going to let that happen.
$1,500 ‘REIT rental dividends’ X 22% = $330 Tax
$1,500 – $330 = $1,170 left in my pocket
Max OOP doesn’t want to have to worry about a 22% tax on the ordinary dividends issued by DOC, or the tax treatment of these confusing “non-dividend distributions”. So I do what I always do; take a simple way out. I hold all of my medical office buildings in either a Roth IRA account or a Traditional IRA Account.
Roth IRA Bucket
My Roth IRA offers tax-free growth for all my investments in that account. This includes medical office buildings held in the form of REITs. In other words, there will be no taxes applied to assets in these accounts when they are withdrawn in retirement or dividends that are issued over the years. In even more words, assets in this account are sheltered from federal taxes kind of like our healthcare premiums are when we buy them from our cafeteria plan. This is because those dollars were taxed at the time I earned them from my day job. I put those dollars into this Roth IRA account with special abilities to shelter us from taxes. Then I took those dollars and invested them into medical office buildings. There are a lot of other superpowers that come along with an account like this, but the main takeaway here is I will never need to worry about how the dividends in this account are taxed. Ordinary shmordinary, the federal income tax just doesn’t apply to assets in this account. My Roth IRA account currently holds about $7,400 of the Max Out of Pocket REIT portfolio. So about $400 of my annual dividend income (as of August 2019) will land in this Roth IRA bucket and thus never land in the 22% tax bucket. Thus they will never be taxed.
Here is that position as of August 2nd:
I suppose I technically can’t predict the future and the government could change the tax rules someday, but I will go out on a limb and say that is extremely unlikely. That said, I am sure the last Czars of Russia thought it was extremely unlikely the entire family would be massacred, but it happened.
Traditional IRA Bucket
My traditional IRA account holds assets where the taxes are deferred until the assets are withdrawn. I still earned these dollars from my day job, they just weren’t taxed at the time I earned them. I diverted them to this special traditional IRA account. They were essentially deducted (subtracted) from my gross income the year they were earned. When they are withdrawn, they will be taxed as ordinary income. This will hopefully occur at a time when I am in a much lower tax bracket and not getting taxed 22 cents on the dollar. The key takeaway here is I don’t need to worry about getting taxed on these dividends until way in the future, so no tax will be applied to this dividend income in the year I receive the dividend. My IRA bucket holds about $14,000 of the Max Out of Pocket Healthcare REIT portfolio and will generate about $1,000 in passive income over the next year.
Here is that position:
My position of DOC (Physicians Realty Trust) held in my brokerage account at the end of the month was $0.00. Ordinary dividends that land in this bucket are considered part of ordinary income and would be subject to regular federal income tax rates as determined by our tax bracket. About 30% of DOC’s dividends are considered ordinary. Since that would mean a 22% tax for Max OOP, so far I have just opted out of using this bucket for holding any of the Max Out of Pocket Healthcare REIT portfolio.
I do have some homework to do here, though. Since only about 30% of Physicians Realty Trust’s dividends are considered ordinary, we do need to get a better understanding of how the other 70% “non-dividend distributions” are handled. So since Friday was payday, I went ahead and made my usual purchase of Physicians Realty Trust. But this purchase was a little different; I squeezed these medical office buildings into my brokerage account. That way we can follow these through to our 2019 tax return. Look at that, I am willing to complicate my life a little bit in the name of Max Out of Pocket.
We will probably need to slow this experiment down soon since the initial plan was to consider holding the portfolio at $25,000. Max OOP has always struggled to stay on track with things.
Even though we re-visit the REIT portfolio every pay-day in a loosely defined version of dollar-cost averaging, until last week, additions to the Max Out of Pocket REIT portfolio typically occurred in either my Roth IRA accounts or Traditional IRA account. I had some cash sitting in my IRA account from a previous employer and also rolled several accounts together into one IRA in late 2018 to simplify the account structure. I have been dumping those funds slowly into the REIT portfolio and using my pay-check income for other allocations to offset purchases made through the Max Out of Pocket healthcare REIT portfolio.
When you hold any investments, you need to take tax into consideration. Since most REITS pay a large dividend and have a component of ordinary dividends embedded in their quarterly distribution, we need to keep our tax bracket in mind when deciding where to hold the REIT.
Since Max OOP doesn’t want to worry about the federal government clipping away 22% of my dividend income, I hold most of these assets in tax-sheltered and tax-deferred accounts so I don’t have to think about it. Take that, 22% federal income tax bucket.
Usual disclaimer, this is just for entertainment purposes and never a recommendation to buy this REIT or any other investment. You are always responsible for your own investment decisions.
Where do you keep your REITS?