REITs are a "Free Lunch" to Roth IRA investors

[TripleB]

I came to a realization tonight that I'd like to share. It's possible I miscalculated something, so please correct my logic if that is the case:

Most publicly traded companies on the US stock exchanges are structured as C-Corps. By law, C-Corps must pay corporate income tax on all income. The current US Corporate tax rate is 35%, but due to various tax shields and creative accounting, most corporations maintain an effective 30% tax rate. Any earnings on the stock price are taxed again to the investor. Both dividends and capital gains are taxable income to the investor.

REITs are specialized structures that hold real estate and are set up as pass-through entities. There is no income tax on REITs at the REIT level. In order to qualify as a REIT, it must pass through 90%+ of taxable income through to investors each year, which is then taxable to the investor.

Imagine an investor with Roth IRA space. Unlike a Traditional IRA, a Roth IRA does not allow for a tax-deduction when contributions are made, however any and all earnings in the Roth IRA come out tax-free.

I propose that holding REITs in a Roth IRA are a free lunch as compared to holding regular C-Corp stocks. A Roth IRA investor holding REITs will *never* be taxed on earnings of the entity they invest in. A Roth IRA investor holding C-Corp stocks will be taxed internally by a reduced stock price.

Suppose the S&P 500 index fund goes up 10% each year on average going forward. The companies on the exchange need to earn over 14% return, in order to pay corporate income taxes, and then wind up with a 10% return for the investor. The investor doesn't notice his earnings are being eroded by corporate taxes because it's hidden by a reduced stock price.

Conversely, if a REIT gains 14% annually, a Roth IRA investor gets to keep all 14%.

There's diversification risk involved, as REITs are a sector play, however S&P500 companies would have to beat REIT's by 40% just to break even considering corporate taxes... for investors holding them in a Roth IRA.

Full Disclosure: Due to tax-strategic conversions, I currently have 80% of my assets in Roth IRAs and this could be a significant savings for me if I decided to switch a large chunk of my Total Stock Market PP equity into REITs. I understand it's not PP anymore, and the standard recommendation would be to do this only in a VP. I am considering putting half of my PP equity into REITs as I feel they track the S&P500 to a reasonable degree and due to the free lunch involved, I immediately recognize a large return.

[KevinW]

I think you're right about the "free lunch" thing. Earnings of most corporations are double-taxed: once as corporate profits and a second time as dividends or capital gains.  REITs are taxed once as regular income to the shareholder, and in a Roth account that never happens.

Keep in mind, though, that REITs primarily own real estate which is usually subject to annual state/local taxes. So this may be a lateral move from paying federal tax to local tax.

I don't think the REIT sector is a suitable surrogate for a broad stock market fund. It's a somewhat counter-cyclical asset class that responds to interest rates differently than typical corporations. In fact slice-and-dicers usually consider it a diversifier against conventional equities. IMO it's a VP play.

[TripleB]

Keep in mind, though, that REITs primarily own real estate which is usually subject to annual state/local taxes. So this may be a lateral move from paying federal tax to local tax.

Interesting point, however I believe the highest RE tax anywhere in the country is 3% annually. Compared to 30% corporate tax and that's nothing. However, I believe most REITs are internally leveraged to a modest degree which would mean they own and pay taxes on several times the value of the equity in their RE.

[KevinW]

Well -- if a piece of real estate has a price/rent ratio of 20, then it pays 5% of its market value in rent each year. If 4% is left over after overhead, and property tax is 1% of market value per year, then taxes take 25% of profits. In the same ballpark as the 30% effective rate you cited.

Leverage, and the various and sundry GE-style loopholes corporations use, make these comparisons even more difficult.

One thing I do like about REITs is that their structure keeps management on a very tight leash. They're tasked with buying and operating a very specific kind of asset with little wiggle room for outsized executive pay, style creep, etc.

[MediumTex]

Keep in mind, though, that REITs primarily own real estate which is usually subject to annual state/local taxes. So this may be a lateral move from paying federal tax to local tax.

Interesting point, however I believe the highest RE tax anywhere in the country is 3% annually. Compared to 30% corporate tax and that's nothing. However, I believe most REITs are internally leveraged to a modest degree which would mean they own and pay taxes on several times the value of the equity in their RE.

30% on earnings and 3% on the value of underlying real estate might not be that different in terms of actual dollars.

[stone]

When Clive was posting a lot about forestry, I noticed that one of those forestry companies had converted into being a forrestry REIT. Perhaps that might have the tax benefits and yet be somewhat different from typical REITs?

[TripleB]

Well -- if a piece of real estate has a price/rent ratio of 20, then it pays 5% of its market value in rent each year. If 4% is left over after overhead, and property tax is 1% of market value per year, then taxes take 25% of profits. In the same ballpark as the 30% effective rate you cited.

That's a great observation.

[WildAboutHarry]

I like your thinking but wouldn't the market simply arbitrage the advantage of the REIT structure away?

If identical (and obviously hypothetical) companies, one a C Corporation and the other a REIT each earn a dollar, the former could pay a 70 cent dividend and the latter could pay a $1.00 dividend.  I suspect the market price would be lower for the former.

The Roth structure simply eliminates the first (REIT) or second (C Corp) tax bite at the dividend apple.

[TripleB]

I like your thinking but wouldn't the market simply arbitrage the advantage of the REIT structure away?

No, because of Roth IRA contribution limits. This is a free lunch only to people who can put REITs within a Roth IRA, and only to the extent of the limit of a Roth IRA.

Much like I have a high yield FDIC insured savings account that yields 1% when t-bills yield 0%. Sure, FDIC isn't as "safe" as a T-Bill but they are pretty damn close. Definitely not 100 basis points apart in risk, yet the market still experiences it. Why? Because entities with billions of dollars of cash cannot put it into FDIC insured accounts and remain under the $250k limit per account.

Thus, investors with less assets actually get a "free lunch."

[WildAboutHarry]

TripleB,

I thought about that, but a Roth shelters ALL sources of income regardless of the corporate way it is paid or taxed.  So if you could get the same return (with similar risk) from a REIT and a non-REIT investment the fact that the investment is in a Roth really doesn't account for the "free lunch" aspect.  That comes from the Roth itself and applies to all types of investments.  And since most REIT payments are taxed as income there is obvious incentive to put them in tax-advantaged accounts.

With FDIC accounts and savings bonds the "little guy" gets a break because of FDIC insurance and savings bond purchase limits.  So these investments really do have some "free lunch" aspects.  Same with muni bonds and non-US investors.  The muni tax breaks are not attractive to that segment of the market, so muni rates tend to be higher than they otherwise would with a larger market.

I'm still thinking about your Roth/REIT hypothesis, though.  I always like getting something for free

[TripleB]

I thought about that, but a Roth shelters ALL sources of income regardless of the corporate way it is paid or taxed.  So if you could get the same return (with similar risk) from a REIT and a non-REIT investment the fact that the investment is in a Roth really doesn't account for the "free lunch" aspect.

True but consider this:

You hold shares of Apple in your Roth IRA. Apple makes a profit, and based on your ratio of ownership of the company you are due $100 worth of profit. However the government takes $30 in taxes from the profit. You net $70.

You hold shares of a REIT in your Roth IRA. The REIT makes a profit, and based on the ownership of the company you are due $100 worth of profit. The government says that because it's a REIT, the REIT doesn't pay taxes and instead all taxes are due by the investor. However since it's in a Roth IRA, you never pay taxes on the $100. Thus, free "$30."

The reason the government allows REITs to be pass-through entities is because they know in 99.99% of situations (which involve investors holding the REIT outside of a Roth IRA), the government gets their tax immediately on that $100 in profit, because the REIT must issue a $90+ dividend to the investor (at least 90% of net profits must be passed through to the investor each year).

However, with Apple, if they make a $100 profit, pay $30 in corporate taxes and, there's $70 in profit left. Apple doesn't have to pay a dividend, and instead your total stock value goes up by $70. There's no taxable event on your part until you sell your shares. You have a built-in tax shelter. To compensate and make sure the government is getting it's "fair share" they immediately take a bite out of Apple's profit through corporate tax because it might be decades before you sell your capital gains and realize a taxable event.

In my mind, it really is a free-lunch to hold REITs in a Roth IRA. I did some more thinking about there being property taxes on the underlying property and at first it made sense that the tax rate could be similar to a C-Corp but viewed in another light, those property taxes are just "Cost Of Goods Sold" in essence. A REIT needs to pay property tax in order to "sell the good" of renting real estate. No person or entity can "sell" renting of RE without paying tax. Combine this with my next point...

On a risk-adjusted basis, REIT returns must equal C-Corp stock market returns if the market is efficient. If shares of Apple, Exxon, and other SP500 companies are providing a greater risk-adjusted return than REITs, then the share price of those stocks relative to REITs Stocks will adjust to equilibrate.

However, due to the limited space that a Roth IRA provides, only a Roth IRA investor can take advantage of the free lunch that comes from the pass-through taxation structure.

[MediumTex]

Would a treasury bond held in a Roth IRA also be a free lunch?

[AdamA]

Would a treasury bond held in a Roth IRA also be a free lunch?

It's a cheaper lunch.

[WildAboutHarry]

On a risk-adjusted basis, REIT returns must equal C-Corp stock market returns if the market is efficient. If shares of Apple, Exxon, and other SP500 companies are providing a greater risk-adjusted return than REITs, then the share price of those stocks relative to REITs Stocks will adjust to equilibrate.

I think that is my point.  The shares of REITS or Apple or Exxon don't know where they are held.  The market determines a risk and tax-adjusted price that should price adjust risk-equivalent investments independent of where they are held.

Now if REITS were only available in a Roth then there would be a free lunch.  And the Roth itself IS a limited free lunch, since there are contribution limits, income limits, etc.  Same with HSA's.  In fact, if you are right, an HSA would be the best place to hold REITS.  You do a pre-tax contribution and do a tax-free withdrawal (for medical stuff).

I'm still pondering this though...

[melveyr]

TripleB,

I totally get your argument.

The next step would be to explore the typical owners of REITs. Perhaps they are largely owned by entities/individuals that have tax advantages. I think many corporations don't pay nearly the same amount of dividend tax as a retail investor. If it is owned largely in this context, the under-pricing might be less pronounced than you originally hypothesized.

Additionally, if the investors that buy REITs are drawing down their portfolios than the tax effect is irrelevant. They, would have just sold shares if the company paid no dividends, incurring a capital gains. I think many old school investors think in this context, switching to "income" investments later in life. If these investors have no desire to re-invest than it makes no difference to them and they would pay the same price that you would as a tax advantaged investor.

[Storm]

Keep in mind, though, that REITs primarily own real estate which is usually subject to annual state/local taxes. So this may be a lateral move from paying federal tax to local tax.

Interesting point, however I believe the highest RE tax anywhere in the country is 3% annually. Compared to 30% corporate tax and that's nothing. However, I believe most REITs are internally leveraged to a modest degree which would mean they own and pay taxes on several times the value of the equity in their RE.

Keep in mind, that's 3% of the total value of the property.  I'm sure corporations would much rather pay 30% of earnings than 3% of total market cap...