How Tax Reform Could Sock Your Stocks

With September coming to a close, the U.S. government is finishing its fiscal year by continuing its string of the worst budget deficits in the nation's history. In order to stop the bleeding, it'll take unprecedented action from lawmakers -- and some once-unthinkable measures have suddenly made their way onto the table for debate.

Among the proposals are several provisions that would eliminate popular tax breaks that millions of taxpayers depend on. Not only will getting rid of these provisions result in higher taxes for individuals, but they'd also jeopardize the welfare of many investments that rely on those provisions. Let's take a look at three tax-savers that could find themselves on the chopping block before the year is out.

1. Exemption for municipal bond interest.
Under current law, municipal bonds that state and local governments issue enjoy a special perk: their interest isn't subject to federal income tax. For taxpayers in high tax brackets, that can result in more than 50% more after-tax income than a regular taxable bond with the same yield.

A recent proposal included in the president's jobs bill proposal wouldn't eliminate the tax exemption on muni bond interest entirely. But it would limit the benefit of the tax break to 28%, making it less valuable for those who pay a 35% marginal rate. As a result, muni bond investments like the iShares S&P National AMT-Free Muni ETF (NYSE: MUB  ) could take a hit.

In addition, companies that help local governments issue muni bonds could also get hurt. In 2010, Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) were the top muni-bond underwriters. Although local governments would likely continue needing debt regardless of whether the tax break continues, higher taxes could make it harder for underwriters to find buyers for the debt -- jeopardizing their credibility.

2. Lower rates on dividend and capital gains income.
You haven't heard much from either party lately about seeking to eliminate the 15% maximum tax rate on dividend and capital gain income. But because of the way the current law is structured, those rates will disappear at the end of 2012 unless lawmakers act affirmatively to extend them.

In an era of low interest rates, investors have increasingly turned to dividend-paying stocks for the income they desperately need. Lower tax rates on that income help income-starved investors make ends meet. But without the provision, tax rates on dividend income could more than double for some taxpayers. Allowing lower rates on dividends and capital gains to end could cause a fundamental shift in the way people invest -- one that could hurt dividend stocks in favor of more tax-friendly investments.

3. Revoking favored status on mortgage REITs.
Among high-yielding investments, mortgage REITs in particular have become the darlings of the dividend stock world. Among the most popular such investments, Annaly Capital (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) have yields of 14.5% and 17.4% respectively. A few, including Invesco Mortgage Capital (NYSE: IVR  ) and ARMOUR Residential (NYSE: ARR  ) , push the 20% mark.

Mortgage REITs earn these amazing yields through a combination of favorable interest rates and big leverage. By borrowing at near-zero rates and buying mortgage-backed securities, mortgage REITs pocket the spread from what they earn in interest on their investments. In addition, mortgage REITs don't have to pay corporate taxes because they qualify as real estate investment trusts.

But the SEC recently requested comments about potentially regulating mortgage REITs in such a way that could either require them to use less leverage or cause them to lose their favored tax status has sent investors scurrying for cover. Whatever form a potential change takes, the effects could be devastating on mortgage REIT shareholders.

Stay safe
Trying to follow what's going on in Washington is like trying to herd cats. But investors can't afford to ignore the big impacts that tax reform and related regulation can have on their stocks. By staying aware of the potential issues, you can weigh the risks now and make an informed decision about whether you want to run for cover before the worst of the storm hits.

With low tax rates on dividends locked in at least through 2012, you don't want to waste any time getting the best-paying stocks you can find. Check out our 13 favorite high-yielding dividend payers in this free Motley Fool special report.

Fool contributor Dan Caplinger expects the worst from Washington. You can follow him on Twitter here. He owns shares of Chimera Investment. The Motley Fool owns shares of Chimera Investment, Bank of America, Citigroup, and Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never needs reform.

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