Retirement Income Investing Selection Factor 7: IRS Form 1099DIV Data

After explaining the core ideas and methods behind the previous six retirement income selection factors, I will complete the list by discussing the last selection factor, IRS Form 1099DIV Data

The usefulness of the 1099DIV in security selection primarily relates to real estate investment trusts (REITs), mutual funds and Business Development Company (BDC) dividends. The 1099DIV form is the annual end-of-year tax reporting that all equities that pay annual dividends to shareholders in taxable accounts must provide. Because a copy of the 1099DIV is sent to the Internal Revenue Service (IRS) for every holder of a taxable accounts, companies are incentivized to make sure the numbers are accurate.

For these taxable accounts, the brokerage should consolidate all 1099DIV data into one report. This service is very beneficial to an retirement income investor. Otherwise, retirement income investors like me would have to deal with 50 to 60 1099DIV forms each year and enter each one individually into tax preparation software or manually onto Schedule B. However, the data contained in the annual 1099DIV can prove valuable in determining the financial strength of the company.

This applies especially to REITs, Business Development Companies (BDCs) and Closed End Mutual Funds (CEFs), which must pass through to their shareholders the tax character of the dividends they receive from the company stocks and bonds they hold. Corporations are considered to be separate taxable entities and so will incorporate all tax characterizations into their own tax return. The only tax character of corporate dividends are dividends that qualify for favorable tax treatment or qualified dividends, dividends that do not qualify for favorable tax treatment, which are rare and perhaps dividends that are in excess of the company’s stated earnings or cash reserves.

However, REITs, Mutual Funds and BDCs generally do not pay a Federal corporate tax. Therefore, these entities must pass certain tax characteristics through to their shareholders. These tax characteristics can tell a great deal about the financial strength of the company, and are as follows:

1. Ordinary Income represents the taxable earnings generated by company operations. A high percentage of the company’s dividends that are characterized on the annual form 1099 as ordinary income is a strong financial indicator. Ordinary income is the first to be distributed and it is distributed first to the preferred stock shares, if any, and then to common stock shares. So, it is not unusual to see preferred stock with 100% of their dividend being ordinary income while a portion of the common stock’s dividend is capital gain and return of capital. But 100% of the common and preferred stock dividends as ordinary income implies the REIT is financially strong.

2. Long Term Capital Gains are the net gains on the sale of property held longer than one year. C-Corporation include these gains in their own taxable income and are taxed at the corporate level and so are not passed through to shareholders whereas with. REITs, BDCs and mutual funds, capital gains pass through to shareholders. Most equity REITs will, from time to time, have a small percent of their dividends as long-term capital gains due to the sale of some of its appreciated property holdings. For a mutual fund, it means the fund sold some of its stock it held at a gain. A REIT that shows a substantial portion of its dividends as capital gains suggests the REIT is disgorging itself of highly appreciated properties. This action may or may not be a poor management indicator, depending on other factors. But a REIT that constantly distributes capital gains suggests that the REIT is “flipping” properties, which will only work when property prices are appreciating.

3. Short Term Capital Gains will only occur when the REIT, BDC or mutual fund sells property for a net gain that it has held less than one year. However, this is not separately reported, but instead is included as ordinary income.

4. Long and Short Term Capital Losses are not reported by a REIT or fund, but instead are held at the REIT or fund and used against future capital gains.

It is important to differentiate between distributed capital gains from a REIT, BDC or mutual fund, and those capital gains we realize when we sell a stock or mutual fund at a gain or loss that is then reported on form 1099-B. These short and long term capital gains and losses, if more than one exists, will be netted out against each other if there is a combination of gains and losses. Once that is done, any distributed capital gains are added to the 1099-B capital gains or subtracted from any 1099-B capital losses. But any capital losses, short or long term, from a REIT, fund or BDC cannot be distributed.

5. Qualifying dividends. Most of a REIT’s ordinary income does not qualify for favorable tax treatment as qualifying dividends to the shareholder because the dividends have not been subject to corporate tax. But there are Taxable REIT Subsidiaries (TRS) that the tax code now allows. Under TRS, a REIT can own a subsidiary that provides services to the REIT and is taxed separately as a corporation if the TRS does not exceed 25% of the REITs assets. Therefore, any dividends representing the earnings of these subsidiaries will be taxable to the REIT and these dividends will qualify for favorable tax treatment as qualified dividends. Most equity REITs do not distribute qualified dividends and for those that do, it is usually a small part of the total dividend.

6. Unrecaptured Section 1250 gains are part of the distributed capital gain of a REIT that represents a recapture of the depreciation deduction that the REIT took in earlier years on the sold property. For purposes of selection criteria, this is equivalent to capital gains. I will discuss tax implications of this tax characteristic along with other tax issues in a future article.

7. Collectable gains and Section 1202 Small Company Stock gains are possible, but extremely rare. Therefore, I will not discuss these in any additional details.

8. Return of Capital is the part of the dividend that is not classified in any of the first six categories above. For instance, the equity REIT Simon Properties Group (NYSE:SPG) distributes $5.00 per share and $3.00 of this is ordinary income, $0.50 is long-term capital gains and $0.50 is Unrecaptured Section 1250 gain with no other classifications of distributable gains for the year. In this case, the last $1 of the dividend will be classified as Return of Capital.

Generally, Return of Capital is a sign that the company is returning part of the company to its shareholders and treating it as yield, which seems misleading on the surface. If someone gives me $1,000 as an investment, I put the $1,000 in a safe deposit box and then withdraw from it and return $100 of it to them last year, can I refer to that as a 10% yield? The answer is that I can as long as I disclose to them that it is a return of capital and not some other form of earnings.

However, with REITs and Master Limited Partnerships (MLPs), the non-cash expense of depreciation is very high relative to their revenues. Therefore, their net earnings as shown on their annual earnings statement will appear low while their Net Operational Cash Flow will remain high. Thus, Return of Capital as part of their annual dividend is quite common. Generally, the percent of the total dividend paid out by a REIT that is Return of Capital should not exceed the percent of the REITs or MLP’s revenue that is depreciation.

Data on the 1099DIV form for most REITs can be found at the website of the National Association of Real Estate Investment Trusts, the industry trade group, at www.reit.com.

Here are some examples of how to use this data in the REIT selection process (all values are per share):

Camden Properties (Symbol CPT)

Type of REIT: Apartment REIT

Yield: 3.8%

2018 dividend/share data: The total distributed to common + preferred shares

            Total Dividend: $3.28/share

            Part of dividend that is ordinary income: $2.99

            Percent of dividend that is ordinary income: 2.99 / 3.28 = 91.2%

            Part of dividend that is capital gains: $0.089044

            Percent of dividend that is capital gains: 0.089044 / 3.28 = 2.7%

            Total Return of Capital (non-dividend dividends):  $0.20

            Percent of Return of Capital: 0.20 / 3.28 = 6.1%

Percent of Depreciation to Revenue (from the Income Statement): 79 / 245 = 32%

These ratios show that 91.2% of Camden’s net income for 2018 is ordinary income from operations, 4.1% of the dividend was capital gains and 2.7% was a return of capital while the company’s depreciation expense is 32% of the company’s gross revenues. This is a good combination and shows that CPT is collecting in rents well in excess of its expenses — including its non-cash expenses.

National Retail Properties (Symbol: NNN)

Type of REIT: Diversified Retail Properties

Yield: 4.8%

2013 dividend/share data

            Total Dividends per share: $4.028125

            Ordinary Income: $3.708241 = 88.3%

            Qualified Dividends: $0.1522 = 3.8%

            Long Term Capital Gains & Unrecap Sect. 1250 gain: $0.003772 = 0.1%

            Return of Capital: $.317998 = 7.9%

            2013 Depreciation to Revenue: 25.3%

These ratios show strong earnings, little capital gains and Return of Capital well below the non-cash depreciation expense percentage of total revenues.

Northstar Realty Finance Corp (Symbol: NRF)

Type of REIT: Diversified Properties and Loans

Yield: 5.3%

2013 dividend/share data

            Total Dividends per share: $7.9475

            Ordinary Income: $1.34064 = 16.9%

            Return of Capital: $6.60681 = 83.1%

            2013 Depreciation to Revenue: 15.6%

These ratios of NRF clearly show a REIT whose net income only covers about 17% of the dividend, with the remainder a return of capital. This shows financial weakness and I would not consider this REIT for retirement income investing.

This concludes the group of articles about individual retirement income investing selection factors. You can find the full series of articles about retirement income investing here on StockInvestor.com or you can find the original source material for those articles in my Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide books on retirement income investing.

Bruce Miller is a certified financial planner (CFP) and retirement income expert who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.