Most investors are familiar with the capital gains and dividend tax rules but some types of investments have lesser known tax rules. Understanding these rules is important to maximizing your returns and minimizing your tax bill. Here are tax treatments for four types of investments you should certainly acquaint yourself with before diving in.
1. REIT preferred stocks
Normally preferred stock dividends are considered qualified dividends, and therefore eligible for a preferential tax rate, if they are held for at least 90 days before and after the ex-dividend date. However, dividends from REIT preferred stocks are not considered qualified dividends and hence are taxed at a higher rate.
So why are REIT preferreds hit with a higher tax rate than other corporate preferreds? It has to do with tax rules to compensate for the fact that REITs themselves do not pay taxes and instead pass at least 90% of their income back to their shareholders.
With many REIT preferreds still carrying above average yields, investors should not rule out investing here but should factor in the higher tax rate to get a better comparison with non-REIT preferred stocks.
2. Exchange traded notes
Commonly known as ETNs, these securities are similar to ETFs except ETNs are actually debt backed by the issuing company. Because of this, income from ETNs is taxed as ordinary income and is not eligible for the qualified dividend tax rate.
But ETNs currently appear to have a tax advantage as well. Under current rules, taxes are deferred until the ETN is sold since there are not actually gains being reinvested as is the case with an ETF. However, this rule may change if the IRS attempts to bring ETN and ETF tax policies more in line.
Since ETNs are often mixed with ETFs in investment screeners and searches, you should always make sure you know whether the security you're buying is an ETF or an ETN. While ETNs can still make good investments, you should take into account the higher tax rate and the issuers credit risk when deciding which investment is better for you.
3. Master limited partnerships
MLPs are one of the hottest investments today thanks to their unique tax status. Unlike shares of a corporation, MLP investors own units of a partnership with the tax implications of partnership taxation.
Taxation of partnership income is typically treated as ordinary income and thus not eligible for the qualified dividend tax rate. However, MLPs are constantly recording depreciation of their assets allowing them to treat much of this income as a tax-free return of capital.
But the tax-free income doesn't last forever. Each return of capital lowers the investor's cost basis until it reaches zero. At this point future payments are treated as ordinary income. Selling the MLP units here would result in recapture forcing you to pay ordinary income rates on the difference between what you paid for the units and your zero cost basis.
Ultimately, the best cure for MLPs with a zero cost basis is death. If you pass on your MLP units to your heirs, the recapture disappears and your heirs start with a higher cost basis once again.
For some further examples of how MLP taxation works, this article in Forbes helps to sum it up.
4. Dividends from foreign companies
Dividends from U.S. based companies are typically eligible for a preferential tax rate, but many foreign nations have a dividend withholding tax to make up for some of the money leaving their borders. In fact, withholding part of the dividends going to foreign investors is a fairly common tax policy and is even replicated by the U.S. on dividend payments leaving its borders.
These withholding taxes vary greatly by country with the some having no dividend withholding tax and others topping 30%. But there are ways to avoid these taxes for investors wanting to invest abroad.
In many cases, part or all of these taxes can be recovered through a foreign tax credit or deduction from the IRS but there still are select cases to watch out for.
Taxes can take a real bite out of your portfolio, especially for those who don't understand the tax implications of their investments. But by selecting more tax efficient investments and properly planning, you can keep you tax bill more manageable. As always, it's best to understand the taxes connected to your investments by doing your research and consulting a tax professional.
Alexander MacLennan is not a tax professional and the information from above comes from his own research. Please consult a reputable tax professional before making tax related decisions. 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 Motley Fool has a disclosure policy.