Taxes! What mREIT Investors Need to Know

Source: 401(K) 2013

Mortgage REITs are great at avoiding Uncle Sam. Thanks to their beneficial tax treatment, they don't pay a dime in taxes so long as 90% of their income is paid out to shareholders.

Unfortunately, that doesn't mean you, the investor, can skimp on taxes. With tax time around the corner, let's look at the tax treatment from mREIT dividends in 2013. Here's a table of the tax treatment for the five largest mREITs: 

mREIT Name

Ordinary dividends

Qualified dividends or capital gains

Return of capital

American Capital Agency (NASDAQ: AGNC  )

$3.75

$0.029963

None

Annaly Capital Management (NYSE: NLY  )

$1.263342

$0.236658

None

American Capital Mortgage (NASDAQ: MTGE  )

$3.05

None

None

Starwood Property Trust (NYSE: STWD  )

$1.4633

$0.4717

$0.0195

Two Harbors (NYSE: TWO  )

$1.16593

$0.136966

$0.951268


Source: American Capital Agency, Annaly Capital Management, American Capital Mortgage, Starwood Property Trust, and Two Harbors investor relations websites and press releases.

How to make sense of taxes due
REITs have a different tax treatment than your average stock. Ordinary dividends in the second column represent amounts on which the shareholder should pay ordinary income tax rates. This is income earned primarily from the spread an mREIT earns by borrowing money cheaply to invest in longer-term mortgage securities.

In the second column are qualified dividends and capital gains, on which shareholders will owe normal capital gains tax rates. Depending on your tax bracket, this could be anywhere from 0% to 23.8%.

Returns of capital
Finally, we have returns of capital -- the tricky part. Returns of capital are not profits, nor capital gains. A return of capital happens when an mREIT returns money that does not come from profits or gains; it's your money coming back to you.

Thus, a return of capital is not immediately taxed. Instead, a return of capital is used to lower your cost basis. If you bought Starwood Property Trust in 2012 at $20.00 per share, the $0.0195 in return of capital would be used to reduce your cost basis to $19.985 per share. So, if you sold today for $30.15, you'd owe taxes on the $10.165 difference between the price at which you sold ($30.15), and your adjusted cost basis ($19.985).

Tax efficiency isn't that important
Unlike other sectors, an mREIT's tax efficiency should really come second to its total return. Just because American Capital Agency, American Capital Mortgage, and Annaly Capital generated higher proportions of highly taxed ordinary dividends, it doesn't make them bad investments. It really just shows that they were booking most of their profits from the normal day-to-day mREIT business -- buying and holding mortgage-backed securities.

In any given year, the tax efficiency for an mREIT will fluctuate dramatically. Some mREITs will sell mortgages at a gain. The next year, they may simply buy and hold, and generate zero capital gains.

Make taxes simple
Want to forget all of the above? Buy mREITs in a tax-advantaged account like an IRA or 401k, where the tax treatment of dividends and distributions simply doesn't matter. Either you'll pay income taxes when you withdraw (traditional plans), or no taxes at all (Roth plans). 

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  • Report this Comment On February 03, 2014, at 10:26 AM, Dryfly55 wrote:

    Isn't there a $2000 earnings limit for LLPs even in tax advantaged accounts like IRAs? Are REITs not in this category?

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