Investing in Real Estate and Raking in Dividends Without Taking a Tax Hit


By Carlos Portocarrero

A few years ago I opened a Roth IRA account with Vanguard because they are the best place for index fund guys like myself.

I built my portfolio with some basics:

  • S&P index fund (VFINX)
  • International stuff (VGTSX)
  • Mid cap stuff (VIMSX)

Not a bad mix—maybe too much stock (100%, actually)—but I was young and figured I didn’t have to dip into bonds for some time.

So I held tight.

Then I started reading about REITs. Real Estate Investment Trusts are securities (like stocks) that allow you to invest in real estate without becoming a landlord.

What’s so special about them? They typically pay a nice dividend because they have to pay out at least 90% of their income (to fit this designation), and that means the people owning the shares get paid.

Sweet!

But that also means you have to pay taxes on those dividends, which sucks.

Then I discovered a way to not pay taxes on dividends: owning dividend-paying stocks in a tax-sheltered account like a Roth IRA.

One more thing: I also have a Roth IRA account with Scottrade, which is where I keep my recently split B shares of Berkshire Hathaway (I’m a huge fan of Warren Buffett) and where I can buy stocks in my Roth at a cheaper cost than with Vanguard.

And that is where I would buy a specific REIT if I found one I liked. And back in 2006, there were plenty to choose from. Among the big names that caught my eye were AHM and New Century. Why? Because their dividend yields were juicy—I think they got up to around 8% at one point.


AHM’s Stock Chart — I dodged a major bullet

At the time I was really responsible about my investments so I got the prospectuses and annual reports and went through all the details.

It seemed the reason these companies were raking in so much dough was because of something called sub-prime mortgages. I had no idea what those were but quickly realized this was a buzz word. Everywhere I saw it, dollar signs followed.

But something about the whole idea of getting 8% back on my money (without any appreciation of the stock) and laying down some serious cash for an investment that seemed too good to be true held me back.

Thank god.

All hell broke loose and subprime mortgage companies went under—AHM and New Century included.

But this idea of owning dividend-paying stocks in my Roth always stuck with me—it seemed like a no-brainer. REITs were still out there making money and paying out 90% of their income in dividends, just not with obscene 8% yields.

And when the shit hit the fan I remembered the wise words of Warren Buffett:

Be fearful when others are greedy and be greedy when others are fearful.

Time to Get Greedy

When the real estate market tanked and the stock market plummeted, I realized this was the perfect time to go in there and buy some damaged goods.

Anything that had a solid foundation that had taken a hit was bound to bounce back.

Including real estate.

But instead of risking my money on one individual REIT, I went to Vanguard. They had an index fund that diversified in a variety of REITs to spread the risk around.

I could put my REIT in a Roth strategy to work with minimal risk for cheap: their expense ratio was only 0.26%, which is what some mutual funds charge.

So I took a hard look at buying Vanguard’s REIT Index Fund (VGSIX). The downside: I needed $3,000 to get in the door. Ouch.

Not only is that a lot of money, at the time it was around 67% of the annual amount I could contribute to the account.

So that meant I couldn’t load up on all the index funds I currently owned that had dropped in price so much. I wouldn’t be able to buy low.

So I passed on this chance.

Now comes the part where I messed up:

That red circle down there? That’s the closest I was to buying in. Price at the time? $8.

Price today? $15. Without dividends.

The Lesson

Well, clearly the first thing I did well was not pull the trigger on buying AHM or New Century when they were rolling in money. Something told me it was too good to be true and I was right.

As Warren Buffett has taught us (did I mention I’m a fan?), sometimes the best deals are the ones you don’t make.

On the downside, I didn’t have the balls to make the second move, which would’ve netted me an 88% return in just over year with tax-free dividends to boot.

And all I have to show is this long, winding post.

Shoot.

This article was included in the massively useful Tax Carnival over on Don’t Mess with Taxes. Check it out for great tax tips as April approaches!


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