No Dividend Tax Debate Here

This article was originally published by Zacks.com.

No matter what side of the fiscal cliff debate you are on, it seems pretty clear that taxes are going up. Both sides are now proposing new increases with some forecasting that over $1 trillion in new revenues will be collected over the next decade.

A big part of this increase could very well be in the form of new dividend taxes. By some estimates, this favorable rate — which is currently at 15% — could nearly triple if we go over the fiscal cliff, pushing these rates (possibly) up to just south of 45%.

This situation has certainly impacted investors that have a dividend focus, pushing down firms that are in traditional high yield sectors. Key dividend stocks in sectors like utilities have been getting crushed, and other firms with big payouts haven’t exactly been doing much better with this cloud of uncertainty.

Yet even with this issue, high payout stocks remain in great demand among a variety of investors, thanks to the low rate environment and the lack of quality alternatives in the bond world. So what is an investor to do if they want to still capture high yields but are looking to avoid the risks that come with a massive dividend tax increase?

Focus on ordinary income

While most securities pay out investors in the form of qualified dividends, there are a few that utilize a different structure in order to have their yields be categorized as “ordinary income.” Generally speaking, this is done to avoid double taxation, but it also results in huge payouts, as usually more than 90% of income must be paid out to investors on a yearly basis.

Although it is true that the current rate on ordinary income — for the top bracket — is also expected to rise, it could still stay below the 40% mark. This means that if dividend rates go up to their highest projected level, income derived from ordinary income focused securities could actually be a better deal from a tax perspective while having less policy risk before any decision is made as well.

If that wasn’t enough, these securities usually pay out more to investors anyway so they could truly become a top yield destination if the worst happens with the Cliff. While individual stocks could certainty be a way to approach this problem, an ETF technique could offer added benefits thanks to the structure and diversification of these products.

So for investors looking for a different high yielding play that could be relatively unscathed by the current dividend issue, a look to any of the following three ETFs may be the way to go.

MLPs

Master Limited Partnerships are often viewed as the “toll roads” of the commodity world. They are usually pipelines or similar types of assets that store or move products like oil or natural gas, making them less sensitive to economic conditions while also having very stable businesses.

As you might be able to guess, these are partnerships so investors do have to fill out a K-1 form at tax time. However, if investors buy up ETNs in this space — which are structured as debt that seeks to track an index — this tax headache is avoided while still allowing for all of the taxation benefits (and high yields) that come from investing in the MLP world.

One of the most popular, and oldest, in this respect, is AMJ, an ETN from JPMorgan. It tracks the Alerian MLP Index, charging investors 85 basis points a year in fees while 50 securities are in the underlying index.

Yields come in above 5% for this ETN, while average volume is approaching one million shares a day. If that wasn’t enough, investors also have a host of other similar ETNs in the space, each of which have a different focus like natural gas (MLPG), infrastructure (MLPI), or high income (MLPY), so there are certainly a variety of options for those who want to take this route.

Real estate

REITs, or Real Estate Investment Trusts, are arguably the most famous of the group and are best known for their outsized payouts. These securities invest in real estate projects or manage homes and buildings, making them a much more liquid way to buy up real estate.

The space has over a dozen ETFs giving investors plenty of choices and various ways to delve deeper into a particular sector. While there are a number of broad funds in the REIT ETF world, the most popular is easily the Vanguard REIT Index ETF (VNQ).

This is an ultra cheap choice — just 10 basis points a year in fees-- that sees great volume of over three million shares a day. The yield is also pretty good, coming in at roughly 3.5% in 30 Day SEC terms suggesting that it could also be a decent yield destination.

The ETF also does a great job of spreading out assets as it has over 115 companies in total. Still, SPG takes up a decent chunk at over 10% of the total, but beyond that the fund is quite even and even puts 50% of the assets in securities that are mid caps or smaller.

BDCs

Arguably the least well-known of the group are firms known as “Business Development Companies.” These firms look to invest in startups and other small companies either by taking debt or equity stakes that are relatively illiquid.

Much like the others on the list, these avoid double taxation by paying out more than 90% of their taxable annual net income to investors. Also, the main way it can be accessed in Exchange-Traded form is via an ETN, so other tax issues like return on capital are mitigated and tracking error is eliminated since it is structured as a debt security.

One of the only ETNs in this space is UBS’ BDCS. The note charges investors 85 basis points a year in fees, so costs are somewhat high, but current yield comes in just below 9.8%. Investors should note, however, that the product isn’t that popular so bid ask spreads may be a little wide, suggesting total costs could be higher.

Still, it is hard to beat from a yield perspective and it does a great job of spreading out assets with four companies accounting for at least 10% of assets and over 28 firms in total. It should also be pointed out that there is a leveraged version of the ETN as well, BDCL, and this pays out a whopping 18.7% per year, although it is certainly more volatile.

Eric Dutram is the ETF Strategist for Zacks Investment Research.

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