This is the first in a two-part series summarizing implications to timber REIT shareholders from expiry of the current tax provisions specific to dividend income.

Fear battles greed once again as chronicled by the business press in the looming “fiscal cliff” faced by U.S. investors and taxpayers.  See, for example, “Stocks Diving off the ‘Cliff’” and other lemming-oriented reports. For those of us nestled in the woodsy world of timberlands and timber REITs, how might changes in the tax code affect timber REIT investments?

How are dividends taxed currently?  In December 2010, President Obama signed into law a two-year extension of many provisions signed into law by President Bush in 2001 (often termed the “Bush-era tax cuts” and enacted in 2002 and 2003).  The extension retained the current 15% maximum tax rate of qualified dividends for most taxpayers and 0% for those in the 10 to 15% ordinary income tax brackets.

What are “qualifying dividends”? These include dividends received by shareholders (1) of qualified corporations and (2) who held the underlying stock for at least 61 days within an IRS-defined 121-day period relative to the ex-dividend dates of the firms.  Importantly for us, this includes dividends paid by real estate investment trusts (REITs).

What happens if the dividend tax rate expires as scheduled on December 31, 2012?  Shareholders would pay taxes on dividend income at their ordinary income tax rate.  Currently, for example, unmarried individuals who earn more than $85,650 and joint-filing married couples who earn more than $142,700 pay basically 35%, on the margin, in Federal taxes.  However, the issue varies with timber REITs because most dividends qualify as long-term capital gains.  Currently, the qualified dividends and long-term capital gains are taxed at 15%. If the current extension expires, capital gains would be taxed at the pre-2003 rates of 20% (still lower than the marginal ordinary income rate paid by most investors).

Ultimately, changes in dividends or net cash received affect valuations as investors compare after-tax yields and expected returns across asset classes.

Part II provides numerical examples to quantify the implications to shareholders. Dr. Brooks Mendell delivers keynotes and workshops related to forest finance and timberland investment vehicles.  Click here to learn about and register for “Applied Forest Finance” on February 7th in Atlanta, Georgia.