Last week we presented arguments for a continuing bull market and a potential bear market. No one knows, of course, what will happen in 2018, but it’s best to be prepared by diversifying your portfolio.
U.S. stock prices are at all-time highs, which could mean that stocks are overvalued and are due for a fall. But moving your money to bonds could be risky, too, given that the Federal Reserve Board is raising interest rates and reducing its $4.5 trillion portfolio of bonds.
So what are your other options?
Alternative investments, such as precious metals, real estate and private equity, have significant potential for hedging, as their returns are typically either not correlated with those of stocks or they have a negative correlation.
A couple of alternatives that may especially be of interest because of the impact of tax reform are real estate investment trusts (REITs) and master limited partnerships (MLPs), which typically invest in the exploration, production or transportation of oil or natural gas.
The Tax Cuts and Jobs Act gives a 20% tax deduction to pass-through business income earned through certain investments, such as REITs and publicly traded partnerships, including MLPs. In addition, the remaining business income is taxable at the lower rates established by tax reform. The top rate, for example, dropped from 39.6% to 37%.
Pass-through entities include partnerships, limited liability companies, S corporations and sole proprietorships, all of which pass their income through to owners’ tax returns, so profits are taxed at the owners’ individual rate.
Investors in REITs and MLPs will not only enjoy tax savings, but the tax benefit could make both investments more attractive and push their returns higher.
However, there are some complications. Only income counting as business income qualifies for the tax break. Such income is reported on Form 1099 by REIT investors and on Form K-1 by MLP investors.
Investment News noted that deductible income will vary from investment to investment. While it may not be difficult to calculate taxes on REIT income, according to experts interviewed, it will be for MLPs. It is also unclear whether mutual funds that invest in REITs or MLPs will qualify for the deduction.
Most shareholder distributions from MLPs are classified as a “return of capital,” rather than business income, because of factors such as depreciation on MLP holdings. Because of the unique way in which MLPs make distributions, though, MLP investors should receive a larger benefit in the year in which they sell their shares.
Tim Steffen of Robert W. Baird & Co. told Investment News, “If you’re considering a REIT investment or partnership investment, this will perhaps make it a little more attractive to you. But if you haven’t invested in these before, this shouldn’t necessarily be the thing that pushes you over the edge to start investing in them now.”