收入实验室的想法：分配资本收益的税收效益

Summary

Capital gains included in CEF distributions have several benefits.

Some of the benefits include lower tax obligation, level-distribution and retaining the same number of shares.

There is a downside though, the fact that capital appreciation is consistently required can become burdensome for some funds.

The fact that CEFs generally distribute out elevated yields in the first place means that during a downturn many have to cut distributions for sustainability purposes.

Co-produced by Stanford Chemist. This article was first released on September 24th, 2019.

Dividend investing is a tried and true investment strategy that has become popular amongst many individuals of every flavor. These are cash payments that represent an investors equity stake in a company and is their share of the profits. For closed-end funds, these are more properly called distributions. At the basic core - dividends are cash that is paid out from the companies income and distributions are represented as cash from multiple sources. These sources can include ordinary income (qualified and non-qualified), capital gains (long and short) and the often misunderstood return of capital [ROC].

The distinction is important as it represents these additional sources, but I wouldn't be too critical on an investor if they call CEF's payouts dividends. At the end of the day - the result is the same. The cash is moved from the company or CEF to the investor. Additionally, companies and CEFs can offer "dividend reinvesting plans" or DRIPs. (Yes, CEF material calls them dividends too, don't they know the difference?) For CEFs, the most typical plan that I see is a fund buying shares on the open market when the fund trades at a discount. When a fund trades at a premium, investors are generally issued new shares at a discount. The most common is at NAV or 95% of the market price. This allows a discount of up to 5% when the shares are delivered to the investor.

We can take a look at the wording from BlackRock's DRIP as described in their consolidated Annual Report.

After the Trusts declare a dividend or determine to make a capital gain or other distribution, the Reinvestment Plan Agent will acquire shares for the participants’ accounts, depending upon the following circumstances, either (I) through receipt of unissued but authorized shares from each Trust (“newly issued shares”) or (II) by purchase of outstanding shares on the open market or on each Trust’s primary exchange (“open market purchases”). If, on the dividend payment date, the net asset value per share (“NAV”) is equal to or less than the market price per share plus estimated brokerage commissions (such condition often referred to as a “market premium”), the Reinvestment Plan Agent will invest the dividend amount in newly issued shares acquired on behalf of the participants. The number of newly issued shares to be credited to each participant’s account will be determined by dividing the dollar amount of the dividend by the NAV on the date the shares are issued. However, if the NAV is less than 95% of the market price on the dividend payment date, the dollar amount of the dividend will be divided by 95% of the market price on the dividend payment date. If, on the dividend payment date, the NAV is greater than the market price per share plus estimated brokerage commissions (such condition often referred to as a “market discount”), the Reinvestment Plan Agent will invest the dividend amount in shares acquired on behalf of the participants in open-market purchases. If the Reinvestment Plan Agent is unable to invest the full dividend amount in open market purchases, or if the market discount shifts to a market premium during the purchase period, the Reinvestment Plan Agent will invest any un-invested portion in newly issued shares. Investments in newly issued shares made in this manner would be made pursuant to the same process described above and the date of issue for such newly issued shares will substitute for the dividend payment date

Some investors choose to reinvest through these means, compounding their returns over time. This is tilted towards a 'buy-and-hold' type investment strategy. At theCEF/ETF Income Laboratorywe will generally take these distributions in the form of cash. Taking that cash and deploying it opportunistically where we see better valuations. This will generally involve a fund at a discount, hence, no real benefit to participating in a DRIP. The strategy is more time consuming and involves more rigorous efforts on the part of the individual.

There are never any guarantees in investing, all investing involves risk. However, dividends and distributions that arealready receivedby the investment is a "guaranteed" payment. Thus, as long as the cash sits in your account, translating into a return and cannot be taken away. It provides instant gratification to investing when so many "growth" stocks can take years to realize any return. And even then, if they don't pay dividends, an investor has to sell shares to realize capital appreciation. Psychologically speaking, dividends can provide the stability an investor may need in times of volatility too. Helping to keep the investor-focused and invested. Of course, dividends can be cut, suspended or canceled at any time. But again, the dividends paid in cash that sit in your account are yours to keep.

Also important to note, when a company pays a dividend the share price reflects the payment and is lowered. Similarly, a CEF's NAV is adjusted by the amount of the distribution. As the assets of the fund are lowered by the equal amount of the payment.

The Benefits

This leads us into the discussion on the capital gains portion of a distribution in CEFs. Equity CEFs utilize portions of capital gains in their distributions - sometimes to a large extent, sometimes a small portion. CEF investors already know that these funds typically have outsized distribution rates relative to other investment vehicles. This is through utilizing various forms of leverage and options strategies. Additionally, through utilizing capital gains in the distributions being another reason for the abnormally large payouts.

CEFs are often structured as registered investment companies [RICs] too. To qualify as a RIC the fund must pay out 90% of the fund's net investment income [NII]. Additionally, they must payout 98% of their realized capital gains. Unrealized gains can sit in a fund forever, potentially.

Beyond the appeal of larger payouts, these capital gains offer a couple more unique benefits. In the form of lowered tax obligations, predictable income and retaining the same number of shares.

Retaining the same number of shares means an investor does not have to sell off assets to realize the underlying appreciation. This is unlike individual companies where an investor typically would sell shares to realize their capital appreciation. However, this doesn't mean a CEF investor can't do the same when their shares appreciate as well. Actually, at the Lab, this is another thing we do, taking advantage of swap opportunities to "compound income on steroids" by utilizing a reversion to the means method.

In general, long-term capital gains are split into three different brackets: 0%, 15% and 20%. Investors in the 10% and 12% brackets fall into the 0% LT cap gains rate. The bulk of investors fall into the 15% LT cap gains bracket until income is exceeded above a certain amount. The 20% applies for those that have incomes of $425,800 for those that file single, $479,000 for those that are married and $452,400 for investors that file as head of household. The source for the data can be found on the irs.gov website.

There are a few exceptions though that are beyond the scope of this publication. Some individuals pay even higher capital gains rates when including the net investment income tax. This is for high earners that hit a certain level of investment income, taxed at an additional 3.8%. This applies to those with net investment income and also have modified adjusted gross income over a certain level. When filing single this amounts to $200,000 and $250,000 when married filing jointly. Every tax payer's situation is different as well. The above is a general guideline for a U.S. investor - invested in U.S. companies and funds. Check with a tax advisor before making any tax decisions, they will know exactly what is applicable for you.

Another benefit of utilizing capital gains is the predictable income that it can provide. If a fund had to rely solely on NII to pay the distribution; then an investor couldn't reliably predict the exact amount of income they were going to receive. This is because the underlying holdings in the portfolio pay out dividends and interest on different schedules. Meaning that the fund receives a varying amount of NII from month to month or quarter to quarter, depending on the fund's distribution frequency. The capital gains (along with ROC at times) allows the fund to make predictable monthly or quarterly payments for the investor.

The reduced tax obligation benefit would only apply to those that hold CEFs in a taxable account, of course.

To give an example of the tax benefits, we can look at a fund fresh in my mind Cohen & Steers REIT & Preferred & Income Fund (RNP).

(Source - Annual Report)

From the fund's Annual Report for 2018, we can see the breakdown of the composition for the distribution. In fact, it is almost a mirror image of their breakdown from 2017 as well. Of the ~$70 total distributions paid out to investors, 62% was attributed as ordinary income, while the remaining 38% was classified as LT cap gains. RNP pays out monthly, at a rate of $0.1240. This works out to an annual amount of $1.488. To put it simply, $0.92 was paid out as ordinary income and approximately $0.57 was paid out as a capital gain for 2018 - and quite similarly for 2017 too.

So, for an investor in the 25% tax bracket, they would pay a 15% rate on 38% of the distribution for the year. Since we are assuming this investor is in the 25% bracket through earnings other than from investments, everything that is paid out to this investor as ordinary income would be taxed at 25% - disregarding any portion that is considered qualified.

This investor, for example, could hold 1000 shares of RNP, translating into being paid $1,488 in total distributions for the last two years. If his total payout was taxed at 25% he would owe $372 in taxes at the end of the year. However, since a portion is taxed at a lower cap gains rate, he will see a lower tax obligation.

Total distributions = $1,488

38% of this total = $565 x 15% = $84.75

62% of this total = $922 x 25% = $230.50

With the above calculations, we arrive at a total tax obligation at the end of the year of $315.25, compared to the $372 if it were taxed all as ordinary income. The $57 in savings isn't a ton, but say this investor purchased 10,000 shares - we would be looking at $570 in "savings." Now, this is also one position in the investor's portfolio of which we would assume the investor had other holdings as well. The additional holdings could benefit from a lowered rate too if they held CEFs that also utilized LT cap gains. Additionally, this is for a theoretical 1-year period, times this by 10 years or a lifetime. The "savings" can really add up!The Cons

While the above is all positive for most investors, there are a couple of drawbacks. As CEFs are required to pay out so much, this leaves little room for growth or share appreciation on the fund itself. But of course, this kind of leads to the main discussion, that capital gains are taxed favorably. I'm just aware that some investors do not look at it this way. It makes sense though that I would personally rather take my capital appreciation over time, rather than hoping I have one at the end of my holding period. To go back to the reference at the start of this article, the cash that is paid out now and hits your account is yours to keep, guaranteed!

The real trouble is when the market turns against us - these capital gains can become quite thin or turn into capital losses - either realized losses or unrealized. Generally, this leads to a distribution cut for many funds.

This can lead to many funds over distributing as well, this leads to destructive ROC. Destructive ROC is when the distribution of the fund ends up eroding the NAV. Simply put, if a fund's NAV is declining year-over-year, the share price is likely to follow. Additionally, as this cash is paid out the yield climbs ever higher and puts the fund in a vicious cycle. As the yield continues to increase, this makes the fund's assets that are left over have to earn a higher amount too. Subsequently, leading to distribution cuts for the long-term viability of the fund.

Like many things, this isn't as straight forward either. ROC can be constructive too. This happens when certain strategies or investments are used such as an options strategy or MLP holdings. This just simply means that ROC is classified in the distribution but NAV increases anyway, to simplify the term. Some funds are even designed with this in mind, to defer tax obligations.

Conclusion

I hope this piece helps spell out the benefits and the downfall of capital gains in distributions. The primary benefits being lower tax obligations and income that can be leveled out over time. Additionally, it means that an investor can hold onto their current number of shares, without having to resort to selling off these assets to realize capital gains.

For most CEF investors the benefit of lower tax obligation can really add up. If an investor is retired and using this income for their day-to-day expenses, this can be a huge saving when it comes to tax time. Generally, when a person is retired and living on a fixed-income, these extra dollars can really help out.

The biggest negative associated with LT cap gains in the fund's distribution is when the market turns against us it is much more likely that a fund will have to cut their distribution. Another point that some investors will question is the fact that many funds don't show price appreciation at the fund level. The shares are generally flat or slightly down. Some are even down a lot on share price alone due to the GFC of 2008/09, I gave a reference to Cohen & Steers Quality Income Realty Fund (RQI) in a prior piece, and how they still have positive total returns even if an investor bought at the fund's peak.

Overall, I'm in favor of taking my capital gains upfront and saving on the tax burdens when it comes to my taxable accounts!

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Disclosure:

I am/we are long RQI, RNP.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.