Co-produced with PendragonY
With the election of a president and changes in the House and Senate, there are a lot of proposals on changing taxes. The proposal generating the most discussion is an increase in the capital gains tax rate. This proposal is to increase the tax rate for wealthier investors to be the same as the top regular income tax rate. This would approximately double the amount of taxes collected from such wealthy individuals from the current 23.8% to somewhere around 43%. With the Senate equally split and a narrow Democratic majority in the House, it remains to be seen what the final rates will look like, but for sure, higher taxes are coming.
Higher Taxes Will Impact Every Investor
Some might say that since this is currently proposed only for very high-income investors, they don't have to worry about it. But the fact is that the total amount of taxes collected from shareholders will be going up, quite dramatically. This will impact every investor in a company even if that extra cash doesn't come directly out of their pocket as taxes. The reason?
- Quite a few investors decide to sell their high-flying stocks with the biggest capital gains in order to avoid the upcoming tax hikes. This will put some selling pressures on FAANG stocks such as Apple (AAPL), Google (GOOG) (GOOGL), Amazon (AMZN), and other Nasdaq stocks (QQQ), where investors tend to make most of their returns from capital gains rather than dividend income.
- There's less money being re-allocated to such growth stocks. This is normal. The less the return potential, the fewer investors are willing to bet.
- The stocks that would be least likely to be impacted are dividend stocks that generate most of their returns to investors in the form of income rather than capital gains.
In fact, according to a study conducted by Goldman Sachs on the impact of capital gains tax hikes from 1987, 1988, and 2013, concluded that the overall equity markets underperformed during the year right before the tax would take effect, but then made up the underperformance, in the six months afterward. However, an important point to be noted: The same study concluded that it is the "momentum stocks" that took the largest hit during such selling and did not recover in the subsequent year. The bottom line, there was plenty of market volatility in growth stocks and permanent losses in momentum stocks.
Dividend Stocks Are The Best Place To Be
If you are worried about the tax selling, and the market turbulence that this is going to create, there's no reason to be. The stocks that will be the least impacted (or not be impacted at all) by these tax changes are those that pay ordinary dividends, such as property REITs, mortgage REITs, Business Development Companies, Master Limited Partnerships, and many "fixed income" and equity closed-end funds (or CEFs). There are plenty of high dividend options to choose from!
In fact, I expect that dividend stocks will see increased demand by investors going forward because they produce profits to their shareholders in terms of dividends rather than capital gains. So, investors do not have to worry much about higher capital gains taxes. The more demand for dividend stocks, the higher the prices get!
I highlight below two great dividend picks, one property REIT and one BDC, that pay most of their dividends as ordinary income and are set to be big winners from the upcoming tax changes.
Pick #1 Realty Income
Realty Income (O) currently yields 4.2% and has actually trademarked "The Monthly Dividend Company" because it pays its dividend like clockwork, on a monthly basis. O has achieved Dividend Aristocrat status by raising their dividend every year for over 25 years. For the past 23 years, O has raised its dividend every quarter. The dividend has never been cut. Getting paid monthly, quarterly dividend raises, and outperforming the major indexes make a powerful argument for investing with Realty Income. But there's more.
Realty Income is a REIT. As such, it's required to pay dividends equal to 90% of its taxable income. How much a shareholder is taxed depends on the source of the cash used to pay those dividends. As a REIT, the vast majority of dividends from Realty Income are classified as "ordinary income" for tax purposes. Shareholders will see minimal impact no matter what tax changes are eventually passed.
Realty Income is a very dependable dividend payer. Even during the worst of the COVID pandemic, Realty Income raised its monthly dividend payment each quarter. Just like it has been doing for 23 years.
In its most recent earnings report, Realty Income reported that it had collected 93.6% of contractual rent and had 97.9% occupancy. AFFO for 2020 was $3.39 a share which comfortably exceeded the $2.794 in dividends paid during the year. The dividend has already been increased twice, once in January and again in April.
Realty Income recently announced the acquisition of VEREIT (VER) in an all-stock transaction. VER shareholders will receive 0.705 shares of O. At closing, the office properties held by VER will be spun off as a new REIT. Realty Income acquired American Realty Capital in 2012. ARCT was a non-public REIT managed by the same management team that originally ran VER back when it was called ARCP. While this acquisition is bigger by gross dollars, it is similar in the relative scale of the companies. That acquisition fueled substantial AFFO and dividend growth for O. We expect this acquisition to improve dividend coverage for shareholders of both companies.
Pick #2 Ares Capital Corporation
Ares Capital Corporation (ARCC) is a BDC (Business Development Corporation) that is a RIC (Regulated Investment Company). ARCC invests in small and medium businesses, the heart of the American economy. These smaller businesses number more than 30 million in this country. They generate about 50% of the GDP and create 64% of new jobs. No wonder why the federal government directed very large amounts of spending at small businesses in each of its COVID relief packages.
These smaller businesses will be the first to thrive following the pandemic, and ARCC, as a main lender and investor, in a very sweet spot. ARCC is set to see its profits soar as these businesses bloom once again, aided by the stimulus packages and the grand re-opening of the economy.
Like REITs, BDCs are pass-through entities, and if they meet certain requirements, they pay no taxes at the corporate level. As such, most of the dividends will be ordinary dividends and subject to regular income tax rates. Typically between 95% and 99% of the dividend from ARCC is taxed as ordinary dividends. ARCC provides details of the annual dividend classification over the years on its website.
The dividend is now 40 cents a quarter and with GAAP net income per share at $0.87 the dividend is well covered. Net Asset Value (or NAV) is now at $17.48, 13% higher than it was a year ago. Another measure of dividend safety is that ARCC has $1.04 per share of cash it must distribute as dividends that it has not yet paid out. With a current yield nearing 8.4%, ARCC closed its fiscal year 2020 with the best quarter in the company's history. Q1 2021 saw even more improvements as NAV increased from $16.97 a share to $17.45. The core EPS of $0.43 a share easily covered the $0.40 dividend. Revenue for the quarter also increased nearly 6% from a year ago. The best is yet to come for ARCC!
Conclusion
Realizing that the wealthiest are being pushed away from investing for capital gains is the first step. Knowing how it will impact your portfolio is the second. In this kind of environment, dividend stocks offer the safest place to be.
Realty Income has a current yield of 4.2% and ARCC with a yield of 8.4% have the vast majority of their dividends classified as ordinary income offer a great place to invest if you are worried about capital gains taxes, the market volatility that it brings along and the potential of permanent losses for "momentum stocks."
I expect to see increased demand for stocks that reward their shareholders with dividends rather than in capital gains such as O and ARCC above. Both are great investments regardless, and the new tax changes will make their outlook even brighter!
If you are like me, saving for your retirement, this is great news. Building your wealth slowly but surely is one of the most satisfying things a person can do for their family. You will be surprised how much more security, peace, and happiness you can have as a result of a well-established, well-managed portfolio of income-generating securities.
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