Investors have flooded into high-yielding dividend stocks to get more income from their portfolios. But now, Congress is looking at potentially taking a bigger piece of the profits that popular high-yielding real estate investment trusts earn, as a Wall Street Journal report explains how the House Ways and Means Committee is looking at potentially revoking a big tax advantage that they've enjoyed for years. If Congress follows through, investors would likely be left paying the price.
What are REITs?
Real estate investment trusts were almost unknown 15 years ago. But between the housing boom and the parallel rise in commercial real estate that largely continued until the 2008 financial crisis hit, REITs have attracted a substantial following among income-seeking investors.
The benefit that REITs enjoy over most companies is that REITs don't have to pay corporate taxes. Instead, they're required to pay at least 90% of their taxable income to their shareholders, who then have to pay individual income tax on what they receive. That may sound onerous, but the net result is to avoid the double taxation that most corporations face, paying tax at the corporate level and still leaving investors to pay taxes on their dividends.
Because of the requirement to pay out the vast majority of their income, REITs often have extremely high dividend payouts. Mortgage REITs ARMOUR Residential (NYSE:ARR) and Chimera Investment (NYSE:CIM) use leveraged strategies to produce yields well in excess of 10%, while Omega Healthcare (NYSE:OHI) and Senior Housing Properties Trust (NASDAQ:DHC), which specialize in long-term care facilities and other properties catering to older residents, both have yields between 5% and 6%.
Why are REITs under fire?
Congress has been looking at a number of potential revenue-raising measures lately, so provisions that involve corporate tax breaks are a natural place to look. Moreover, many companies have been looking to take advantage of REIT status for all or a part of their operations, leading to concerns that the REIT format is being abused. Forest-products and timber giant Weyerhaeuser (NYSE:WY) converted itself to a REIT back in 2010, using its extensive timberland holdings as justification for the move. But recently, even casino operator Penn National Gaming has looked into putting its real-property holdings into a separate REIT as a possible tax-savings mechanism, with the company having gained the support of the Pennsylvania Gaming Control Board last week to take the step toward REIT status.
One reason REITs aren't in as much danger as other beneficiaries of tax breaks is that the revenue impact from revoking REIT status isn't as large as one might think. Currently, REIT investors pay ordinary tax rates on distributions, which can be as much as 20 percentage points higher than the rates that would apply to dividends if the favorable REIT tax status were revoked. The federal government would collect corporate taxes from the former REITs directly, but the net tax impact might not be all that large of a gain for the IRS.
Keep your eyes open
Nevertheless, as more companies look at REIT status, the odds of the tax break disappearing completely go up. For now, REIT investors should keep their eyes on Washington, understanding that if Congress passes a measure eliminating REITs' tax benefits, their dividend yields could potentially take a big hit.