Help w/ REITs in a taxable account

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Topic Author
smackboy1
Posts: 1233
Joined: Wed Mar 14, 2007 9:41 pm

Help w/ REITs in a taxable account

Post by smackboy1 »

Help. Last year I wanted to get some REIT exposure but I had no room in my IRAs (still don't). So I bought REIT ETF (VNQ) without thinking too much. 1 year later I'm up about 20% (before taxes) and I'm learning about holding REITs in a variable annuity. Is it worth selling all the VNQ to buy a VA? Should I just keep the VNQ? Should I just forget about REITs diversification benefits and put the $$$ elsewhere? I can't even begin to figure out how to do that calculation. I'm 38, in the 33% bracket, might still be in a high tax bracket after retirement, and also quite confused.
Disclaimer: nothing written here should be taken as legal advice, but I did stay at a Holiday Inn Express last night.
PatrickS
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Joined: Sat Feb 24, 2007 6:38 pm
Location: San Diego

Not enough info

Post by PatrickS »

I have a spreadsheet I put together comparing holding reits in taxable versus the Vanguard VA. Without knowing your marginal tax rate (you failed to mention your state tax bracket) I couldn't tell you where the break even point is, but I ran it for two scenarios for myself. I'm bordering on the 33% federal bracket and will sometimes be 28%, sometimes 33%. My state bracket is 9.3% (CA).

For 28%/9.3%, the VA comes out better from year 10 onward. For 33%/9.3%, from year 8 onward.

I opened a Vanguard VA for reits this year.
Topic Author
smackboy1
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Joined: Wed Mar 14, 2007 9:41 pm

Re: Not enough info

Post by smackboy1 »

PatrickS wrote:you failed to mention your state tax bracket
Ooops, it's 6% (NJ). Are there any downsides to REIT VA compared to REIT fund in a non-deductible IRA except for the higher fees for the insurance wrapper? Thanks.
Disclaimer: nothing written here should be taken as legal advice, but I did stay at a Holiday Inn Express last night.
PatrickS
Posts: 51
Joined: Sat Feb 24, 2007 6:38 pm
Location: San Diego

Post by PatrickS »

You come out with a VA advantage at year 9 with a 6% state tax. I'm ignoring AMT in my spreadsheet though, so I don't know how accurate it really is.

The insurance wrapper (cost) is the only real disadvantage I know of. I use non-deductible iras as well, but I could never get to my asset allocation amount if I'm limited to the annual contribution limit for my wife and I.
ohiost90
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Re: Help w/ REITs in a taxable account

Post by ohiost90 »

smackboy1 wrote:Help. Last year I wanted to get some REIT exposure but I had no room in my IRAs (still don't).
What is stopping you from selling something(tax efficient) in your IRA to make room for a REIT and then buy what you sold in your tax account?
Topic Author
smackboy1
Posts: 1233
Joined: Wed Mar 14, 2007 9:41 pm

Re: Help w/ REITs in a taxable account

Post by smackboy1 »

ohiost90 wrote:
smackboy1 wrote:Help. Last year I wanted to get some REIT exposure but I had no room in my IRAs (still don't).
What is stopping you from selling something(tax efficient) in your IRA to make room for a REIT and then buy what you sold in your tax account?
My IRAs only account for 5% of my portfolio. To put REITs in my IRA I would have to put bonds in a taxable accounts. As it is there isn't even enough room for all my fixed income allocation.
Disclaimer: nothing written here should be taken as legal advice, but I did stay at a Holiday Inn Express last night.
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alvinsch
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Post by alvinsch »

When REIT dividends were much higher it made sense to use the VA if one was in the highest tax brackets but now it's not so clear. Here's an example assuming a 30 year time frame.

Assume REIT's have a total return of 8% of which 3.5% is a taxable distribution at 33% (4.5% deferred gains) and assume this is liquidated with a 15% CG tax rate. Then compare this against putting it in a VA with an additional 0.4% ER (.61-.21) and also liquidating in 30 years in 33% tax bracket.

VA calculation: ((((1.08-.004)^30)-1)*.67)+1=6.362

Taxable after tax calculation:
[ (r + y)^n - t * (r-1) * ((r+y)^n - 1) / ((r+y) - 1) ]
where
r =1.045; unrealized cap gain
y = 0.02345; after tax distribution return (3.5%*.67)
t = .15; tax rate on cap gains
n = 30; number of years

(1.06845^30)-(.15*.045*(1.06845^30-1)/.06845) = 6.668

So in the VA $1 grows to $6.362 after tax in 30 years while in taxable it grows to $6.668. Even if CG rates go up to 20% the taxable still wins at $6.462. The case where the VA wins is if you can defer taxes until hopefully your tax bracket goes down in retirement. If we assume you can withdraw your VA in the 28% then it's after tax return becomes $6.762 beating out the taxable by 30 years.

With regard to putting REITs or bonds (muni's in your bracket) in taxable I'd look at it as follows. The compound after tax return of the REIT in taxable is: 6.668^(1/30) = 6.529%, so one is losing 1.47% (8.0-6.53) to taxes annually.

If one assumes that taxable bonds and muni's break even in the 28% tax bracket then one could say that if bond yields are greater than 1.471%/.28 = 5.25%, then keep bonds in IRA but if yields are lower it might suggest putting REIT's in IRA. Of course right now rates are in that range and with the uncertainty of the assumptions it's impossible to know what would be better.

Bottom line is that with today's lower REIT yields I wouldn't use the VA unless your tax bracket is going to drop noticeably before you take the money out in 30 years. Hopefully someone will confirm the math.

Hope this helps.
- Al
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alvinsch
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Post by alvinsch »

I forgot to add that we also have under 5% in IRA's so I've put half in REITs and half in ST bonds and then do lots of rebalancing where it is tax free. My assumption was that being able to rebalance is better than only having REITs with no rebalancing (I'm not putting them in taxable), but who knows as it results in less REITs so less diversification.

If you could just tell me the long term return of REITs and bonds going forward along with future tax rates, I could give you a more precise answer. ;)

- Al
PatrickS
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Post by PatrickS »

I was assuming all gains from reits were taxable as ordinary income! I looked at the Vanguard reit index latest distribution and found the following-

Return of Capital $0.04432 (Tax treatment???)
Dividend $0.21045 (taxed as regular income)
ST cap gain $0.00615 (taxed as regular income)
LT Cap Gain $0.19825 (federal lt cap gain rate, state regular income in CA)
Unrecap Sec 1250 Gain $0.03083 (tax treatment???)

Does anyone know what the tax treatment is for the items I listed with question marks?
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LH2004
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Post by LH2004 »

PatrickS wrote:Return of Capital $0.04432 (Tax treatment???)
No tax, it reduces your basis (unless your basis is already zero, in which case it's capital gain)
Dividend $0.21045 (taxed as regular income)
The preferred term is "ordinary income."
ST cap gain $0.00615 (taxed as regular income)
Ordinary income rates, but the actual tax treatment (and desirability of holding directly) depends on whether you have (or can arrange to have) capital losses to offset.
Unrecap Sec 1250 Gain $0.03083 (tax treatment???)
Special 25% rate (again, depending on whether you have capital losses to offset).
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