This article was co-produced with Mark Roussin and Nicholas Ward.
Having a basic understanding of how taxes can impact your investment decisions can go a long way for investors and save you significant amounts of money over the long-term.
For those of you less familiar with the tax code, there are two main types of gains investors can have: short-term or long-term.
There are ways to limit the taxes on these gains, but here is a simple explanation on the differences between short-term and long-term gains.
Short-term capital gains are those that have been realized within a 12-month holding period
Long-term capital gains are those that have been realized with investments that were held OVER 12 months
The importance here is due to the fact that these types of gains are taxed at different rates.
It is always important for investors to take capital gains into account when deciding whether to sell an asset or not because payments to Uncle Sam cut into perceived profits.
If investments, like stocks, are held in a retirement account, then these rules do not apply, but for those investments that are held outside of a retirement account, chances are they can be taxable when sold.
Long-term capital gains are taxed much more favorably than short-term gains.
Long-term capital gains are taxed at 0%, 15%, or 20%, based on various income thresholds.
Here is a look at those thresholds for the 2022 filing year:
0% Long-Term Capital Gains tax:
Single: taxable income of $0 to $41,675
Married: taxable income of $0 to $83,350
Head of Household: taxable income of $0 to $55,800
0% Long-Term Capital gains tax:
15% Long-Term Capital Gains tax:
Single: taxable income of $41,676 to $459,750
Married: taxable income of $83,351 to $517,200
Head of Household: taxable income of $55,801 to $488,500
20% Long-Term Capital Gains tax:
Single: taxable income of $459,751 or more
Married: taxable income of $517,201 or more
Head of Household: taxable income of $488,501 or more
Most taxpayers pay a capital gains tax rate of 15% or less.
Again, to be taxed, one must have “realized” gains, meaning they have sold the asset and thus are required to report the gains.
Any unrealized gains are not taxed.
On the flip side, for those assets that were held for less than 12 months and sold at a gain, those profits are taxed as ordinary income.
Here are the tax brackets for 2022:
As you can see from the IRS chart above, those in the highest tax bracket could see their short-term capital gains taxed at a rate as high as 37%.
Strategizing With Tax Loss Harvesting
Tax-loss harvesting is a strategy that is implemented by many investors to offset potential capital gains taxes, usually performed at the end of the year.
Given the year we have seen in the stock market in 2022, this strategy will likely be more popular than ever.
The idea of tax-loss harvesting is to sell certain positions in which you are currently sitting in a loss position. The idea behind this strategy is to lower your annual capital gains tax, both short-term and long-term.
The idea of locking in losses may put a bad taste in investors’ mouths; however, tax-loss harvesting can provide financial benefits, especially by offsetting high cost short-term capital gains against short-term capital losses.
Let’s look at an example.
If you owned a position for less than a year and sold it for a $1,000 profit, you would be required to pay short-term capital gains tax in-line with your ordinary income tax rate, as we saw above.
However, let’s say you have another position that you have held for less than a year, and you are currently sitting in a position with a $750 unrealized loss.
If you choose to sell that asset at a loss, that $750 loss will now become realized and it will offset against your $1,000 gain from earlier, thus bringing down your short-term capital gains to $250 and therefore, lowering your tax burden.
The same works for long-term capital gains.
The net result of your long-term capital gains and losses can be offset against one another.
Once you have exhausted those options, the tax code then allows for short-term capital gains and losses to offset long-term capital gains and losses.
There are some important decisions to be made when utilizing this strategy.
This strategy could be beneficial if you believe the market will turn negative in the near term.
After all, if you sell a position as part of a tax loss harvesting strategy and the stock moves higher, in the end that would be a negative, but if the markets move lower, taking the loss now and having it offset against gains would be beneficial.
If your losses are greater than your gains to offset, harvested losses can be carried forward to be utilized against gains in future years.
Wash Sale Rules
Another decision to be taken into account when selling a stock as part of a tax loss harvesting strategy is to understand the Wash Sale rules.
The “Wash Sale” rule prohibits investors from selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale.
This means that when you choose to sell a specific stock, you are unable to buy it back until the wash sale period has expired, otherwise you will not be able to write off the investment losses for taxes.
Another thing to consider is how much you like the position you are contemplating selling and whether it fits within your long-term plans.
If you do like a specific stock, it could make more sense to keep the stock and have it surpass the one year mark, which would lower the future taxes on any gains.
Selling out of a position you want to buy back into (after 30 days) would end up resetting the clock on the holding period for that particular stock.
Does The Strategy Work?
So does tax loss harvesting actually work you might ask.
Researchers at MIT and Chapman University calculated that tax loss harvesting yielded almost an additional 1% annual return each year from 1928 to 2018.
Overall, tax-loss harvesting can be a great tool for investors to utilize, especially in down markets.
Not only can you sell positions to offset any realized gains, thus lowering your tax bill, but in down markets you can redistribute those proceeds to other positions on your watchlist at bargain prices.
The key though is to not force it and get away from your long-term strategy for your portfolio. Also, for investors below the income threshold, this strategy would not owe anything in terms of taxes, so utilizing it would not make sense
Once positions are sold for a loss, investors are able to put them to work immediately (if they so choose), into an investment that is not “substantially identical” without breaking the wash-sale rule.
Unfortunately, the IRS is not very clear on what is determined to be “substantially identical” and therefore, there is a gray area here.
Therefore, we insist that investors consult with a professional tax adviser or financial planner before attempting to make such a trade (because voiding the tax loss by breaking wash-sale rules would defeat the entire purpose of locking in losses for tax purposes).
One easy way to avoid this situation is to wait 31 days to make a purchase with the proceeds.
But, for investors who are looking for potential replacements for beaten down stocks that they might have sold, here are some of our favorite REITs from various sub-sectors of REITdom…
After recent sell-offs in the tech-oriented REIT space, we really like American Tower (AMT), Crown Castle (CCI), and Digital Realty (DLR).
Now, selling one and buying the other may fall under the “substantially identical” situation – so once again, check with your tax professional before making that type of tax-loss trade.
The same thing could be said of replacing stocks with others from specific subsectors of REITdom.
Doing so would be very easy. After the 2022 sell-off in the real estate sector (which is currently down by 28.6% on a year-to-date basis), you don’t have to look hard to find a given REIT’s peers that are also trading with attractive valuations.
And while I don’t think that a company with a different management team, which owns different buildings in different cities with a different balance sheet and a different growth strategy should qualify as “substantially identical”, there is a chance that the IRS disagrees.
Therefore, when thinking about how to use REITs best within a tax-loss harvest plan, I think investors should consider replacing non-REIT stocks with their real estate alternatives.
What I mean is this…
Let’s say that a theoretical investor locked in losses on a big-tech investment during 2022 (that area of the market has certainly been hurt badly by rising interest rates) and wanted to maintain exposure to the secular growth trends that many of the tech stocks benefit from…well, then the tech-centric real estate plays would likely offer an intriguing opportunity.
Digital Realty shares are down by nearly 43% on the year and currently trade with a 15.6x blended AFFO multiple.
This valuation is well below the stock’s 5-, 10-, and 20-year average P/AFFO ratios of 21.6x, 19.5x, and 20.3x, respectively.
Sure, DLR shares aren’t expected to provide high bottom-line growth in the near-term as capex in the tech space slows due to a deteriorating macro environment (right now, the analyst consensus for full-year 2022 and 2023 AFFO growth are just 1% and 2%, respectively).
However, even without fast near-term growth, DLR provides investors with 20%+ total return CAGR upside potential over the next couple of years based upon the stock’s 4.9% dividend yield and multiple expansion (mean reversion) prospects, alone.
American Tower shares aren’t quite as cheap (on a relative basis to historical averages); however, they offer better growth prospects.
AMT shares are down by roughly 26.5% on the year and currently trade with a 21x blended AFFO multiple, which is below their 5 and 10-year averages of 25.6x and 23.3x.
AMT’s yield is lower than DLR’s at just 2.78%.
However, even so, the combination of that nearly 3% yield, the stock’s mid-to-high single-digit annual AFFO growth prospects, and the prospects of multiple expansion via mean reversion represent a total return CAGR upside potential of nearly 15% over the coming years.
Lastly, we have CCI, which also offers double digit total return prospects moving forward, in our estimation.
Crown Castle shares are down by 32.06% on a year-to-date basis, pushing their blended P/AFFO ratio down to just 18.44x.
Once again, this is well below historical averages.
CCI’s trailing 5- and 10-year average P/AFFO multiples are 23.8x and 21.1x.
CCI currently yields 4.65% and with mid-single digit AFFO growth prospects in mind (management guides for roughly 7% growth over the long-term), we see total return CAGR potential of 14% to 18%, depending on whether you believe the stock should revert to the 21x or the 23x level.
Now, let’s say that an investor took a bath on home builders, home appliance names, or even home improvement retailers, all of which are down big in 2022 with mortgage rates soaring, but still wanted to maintain exposure to the residential housing market?
Well, then the beaten down apartment REITs offer intriguing opportunities after their year-to-date sell-offs.
Looking at the multi-family REITs that we track at iREIT, 3 have earned iREIT IQ scores (our 1-100 quality rating system) above 95.
They are Camden Property Trust (CPT), with a 97/100 iREIT IQ score, Essex Property Trust (ESS), with a 95/100 iREIT IQ score, and Mid-America Apartment Communities (MAA), with a 99/100 iREIT IQ score.
All three of these companies are expected to produce strong double digit AFFO growth in 2022.
Furthermore, they’re all expected to produce positive bottom-line growth in 2023 and 2024 as well, meaning that the strong compounding process that they’ve experienced during the post-pandemic apartment boom isn’t likely to end anytime soon.
And most importantly, not only do all 3 of these stocks offer investors exposure to extremely high quality operations, but they also all trade with attractive margins of safety.
Relative to iREIT’s fair value estimates, Camden trades with a 17% margin of safety, Essex trades with a 30% margin of safety, and Mid-America trades with a 9% margin of safety.
So, with that in mind, it makes a lot of sense to us to take advantage of losses in the builders/home improvement industries and potentially reallocate those funds to the apartment REITs, all of which offer strong double digit upside (and higher average dividend yields) than their non-REIT peers in the residential housing space.
Look at Essex, in particular, which is trading with a valuation that is in-line with its COVID-19 lows while offering investors exposure to a safe, 4.2% dividend yield and reliable AFFO growth prospects.
Mean reversion here, back up to the 20x area, would provide a total return CAGR of 20% over the next 2 years.
Or, what if this theoretical investor took huge losses on names in the logistics/shipping space, like a FedEx (FDX), United Parcel Service (UPS) or even an Amazon.com (AMZN), all of which are down double digits on the year thus far…but still wanted to maintain exposure to the secular eCommerce growth trend?
Well, our favorite industrial REIT is a potentially really attractive option here.
Prologis (PLD) is a blue chip REIT with a perfect 100/100 iREIT IQ quality rating.
And yet, despite this immense quality, the stock is down by 31.3% during 2022 thus far.
PLD shares currently trade with a 26.2x blended AFFO multiple, which is in-line with its long-term average of 25.5x.
However, over the last 5- and 10-year periods, PLD’s average P/AFFO multiples have been 28.7x and 28.4x, respectively.
Therefore, the stock’s current multiple represents a discount to recent averages and to us, the stock’s 2022 pullback represents a wonderful opportunity to get long one of the highest quality REITs in the market.
PLD is expected to post 30% AFFO growth in 2022. And, looking ahead to 2023, we wouldn’t be surprised at all to see this double digit AFFO growth trend continue.
This sort of growth, alongside the stock’s safe and fast growing dividend (PLD yields 2.77% and provided investors with a 25% raise in early 2022), more than justifies the current 26x premium, in our opinion.
Critics of PLD will say that the stock really struggled during the Great Recession; however, our counter argument is clear: the world has changed immensely since 2008/09 and the rise of eCommerce and advanced manufacturing/logistics capabilities has turned PLD’s assets into mission critical hubs for many of the world’s largest companies.
This is a very easy company to buy and hold when it’s trading for fair value (or below) and those moments have proven to be relatively rare throughout the last decade or so.
But, right now, we believe that PLD shares offer a 24% margin of safety, meaning that this stock offers both quality and value, to boot.
Tax-Loss harvesting is an important concept because it leads to improved after tax results for investors. It’s not what investors earn, it’s what they keep that really matters. And tax loss harvesting is one way to help investors keep more of their investment earnings.
As I informed readers recently, “2022 was a tough year for real estate investment trust (‘REIT’) investors. A very tough year, in fact. This is the first time in over a decade that my top picks lost money.”
Nonetheless. I’m very excited about the opportunities in 2023, and in a few days I’ll be releasing my 2023 REIT Roadmap for iREIT on Alpha members.
Why am I so passionate with REITs?
Answer: Real estate drives everything that we do.
Every single industry on the planet requires some sort of real estate to survive/thrive.
Therefore, when looking at an annual tax-loss harvesting strategy and thinking about alternative investments that not only maintain exposure to growth trends from the 10 other sectors, but also increase the quality of one’s holdings and the passive income that they produce, we believe that investors don’t need to look any further than blue chip REITs.
Remember, you gotta know when to hold ’em, fold ’em, walk away, or run.
Happy SWAN Investing!
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.