InnOvation Capital & Management, LLC
IntelDigest
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
OCTOBER 5, 2016
Contact Richard Power with comments or questions. IntelDigest is intended for the use of our clients and colleagues. Material may not be reproduced, forwarded or shared without express permission.
In this issue of IntelDigest, we will discuss federal taxation of investors. This will not be a policy discussion or speculation of tax law changes in the next president’s administration … that can wait until after the election. We will set out the current tax rules and how they affect particular kinds of investments. We have made several suggestions regarding various asset classes in recent issues, and you should know how such investments will be taxed.
Before beginning that discussion, we have a few words about the consequences of a December interest rate hike by the Federal Reserve.
It is likely that The Fed will make a token rate hike in December, perhaps as much as 50 basis points (0.50%), or perhaps just 25 basis points (0.25%) like last December. So, how will such a move affect your investments in bonds, stocks, and gold?
Bonds
A general rule of thumb regarding bonds is that the value of a bond will come down as short-term interest rates rise; and, the amount that the value comes down correlates to the duration of the bond. For example, if interest rates rise by 100 basis points (1%), the value of a long bond with eight years left to maturity will generally come down by 8%. This is NOT a hard-and-fast rule, and there are exceptions. But, as an investor, you should expect such an impact on your bond investments when interest rates rise.
Expecting a modest rise in short-term rates, as indicated above, would most likely result in a modest decline in the value of your bonds. Of course, holding onto your bonds until the maturity dates … whether months or years into the future … allows you to collect the full par value of the bonds. In the meantime, be aware that the values of your bonds can fluctuate as short-term interest rates change..
This applies to corporate bonds as well as Treasuries.
Stocks
The impact on equities of a rise in short-term interest rates depends on how artful the Federal Reserve governors are in presenting the case for higher rates. We have argued that The Fed can “schedule” a number of rises in advance … for example, announce that rates will rise by 50 basis points each December for the next three or four years.
Everyone in business hates uncertainty!! We believe that stocks will fall for only a few days or weeks after the announcement. After that, the expected increases would be “baked into the cake” of asset prices going forward; the markets would likely recover quickly and even march higher IF the economy improves.
Business tends to do well when there is a level of certainty in the marketplace.
Gold
Traditionally, gold prices have tended to go down when interest rates go up, mainly due to carrying costs. Gold pays no interest, so it has a negative carry. Compared to bonds, money market funds, and dividend-paying stocks … which have traditionally paid out a return of 4-5% or more … Gold was at a disadvantage.
However, we are in an environment where bond and money market yields are close to Zero. Many government bonds around the world now trade at Negative interest rates; taking inflation into account, Cash has a negative interest rate as well.
For the first time in history, Gold has a positive carry compared to cash and government bonds. Central banks, investment banks, and large money managers have bought significant amounts of Gold over the last few years, pushing up the prices of Gold, gold funds, and mining companies.
Gold prices have corrected over the last two months; but, if The Fed keeps interest rates low, and the US Dollar maintains its current level, the gold price should resume its rise.
Even if The Fed raises short-term rates, we expect that Gold will rise even faster! Any hike of U.S. interest rates will attract hundreds of billions of Dollars from foreign investors seeking yield; this money will likely flood into U.S. bonds.
As the U.S. bonds are bid up, their yields will come right back down again. And, as these yields go lower, the positive carry of Gold will become more pronounced, likely leading to a rally in Gold into 2017.
The same thing happened last December after a Fed hike of 25 basis points.
Taxation of Investments
Bonds and other Short-Term Holdings (including most options trades) have similar tax treatment. Interest income is treated as ordinary income and is taxed in the highest tax bracket of the taxpayer. If the bond or option is held for one year or less, then it is a short-term holding and is treated as ordinary income. You can save taxes by making such investments inside a tax-advantage account, such as an IRA or other qualified retirement account. (Note that distributions from IRAs and other retirement accounts are treated as fully-taxed ordinary income).
On the other hand, municipal bonds typically pay tax-exempt interest, so it makes sense to hold municipals in a standard (taxable) investment account.
Dividends from publicly-traded equities are usually classified as qualified dividends, which allows them to be taxed at 20% or less, which is lower than the rate on ordinary income paid by most investors, and approximately half of the top ordinary tax rate. For an individual with taxable income below $415,050 ($466,951 for married filing joint), the tax rate on qualified dividends is only 15%; if your taxable income is more, you still pay only 20% tax. Taxpayers in the lower tax brackets could have a tax rate on qualified dividends as low as Zero!
Long-term capital gains (on stocks and other assets) are taxed similarly, so it can make sense to hold publicly-traded stocks in a standard (taxable) account because of the built-in tax benefits.
Preferred Shares of publicly-traded stocks offer special dividends which are practically guaranteed and are paid out before any common shareholders get theirs. One must review the prospectus of any preferred offering to determine whether these dividends are treated as qualified dividends or fully-taxed ordinary income.
Real Estate Investment Trusts (REITs) are required to distribute 90% of taxable income to unit holders to avoid paying corporate taxes. The payouts from REITs are then taxed to investors as ordinary income, which could be as high as 39.6%, depending on each investor’s top tax bracket.
Note that if you wish to reduce your tax on a REIT by holding it in a tax-advantaged account, such as an IRA, you could run afoul of the rules on Unrelated Business Taxable Income (UBTI), which could jeopardize the tax-exempt status of your IRA. Remember that if the income from a REIT is classified as UBTI of $1,000 or more, the investment is inappropriate for an IRA.
Master Limited Partnerships (MLPs) are similar to REITs in their tax treatment. Typically, some of the payout is treated as ordinary income in the current year, and much of the payout is classified as a tax-deferred return of capital in the current year. Most of that return of capital will be taxed, eventually, as ordinary income in the year that the asset is sold.
Like REITs, Business Development Companies (BDCs) avoid corporate taxes if they pay out 90% of earnings to the shareholders. Distributions typically include tax-advantaged qualified dividends, fully-taxable ordinary income, and tax-deferred return of capital (like MLPs, above). As distributions usually include a large amount of ordinary income, these investments usually work best in your tax-advantaged IRA.