Real Estate vs Dividend/Interest

Investing is when individuals earn money (or lose money) when putting in capital instead of time. The two most popular forms of making investment income are through dividends and interest.

Dividend income is earned when taxpayers own stock in a corporation that issues a dividend (money that is paid out regularly - typically quarterly - to shareholders).

Interest income is earned when taxpayers own a bond that pays interest or park money in a savings account.

The issue is that 100% of both dividend and interest income will be subject to income tax. Another layer to factor in is state taxes if you are living in a state that taxes portfolio/investment income. 

The capital gains tax placed on qualified dividends is less than the federal income tax rates place on ordinary dividends. Qualified dividends are taxed at 0%, 15% or 20% depending on your tax bracket. There is also an additional tax called Net Investment Income Tax (aka NIIT or Obamacare tax) of 3.8%.

High income earners can expect their tax rate to be around 23.8% for qualified dividends or 40.8% on interest income. Expect to add another 10% if you live in a state with a high tax rate.

A much better investment strategy for high income earners is to invest in rental real estate. This strategy allows you to earn rental income by renting your property to a tenant.

You are not taxed on gross rental income but instead on net rental income. You are eligible to write off cash outflows such as mortgage interest, insurance, real estate taxes, travel, repairs, etc. One additional expense the IRS gives you, which is what makes real estate investing so great, is depreciation. Depreciation expense is a non-cash tax expense based on the purchase of a property that the IRS gives you regardless if the property decreased in value. A taxpayer can earn positive cash-flow from rental real estate and pay $0 in taxes thanks to depreciation.

Example – High Income earner in the top bracket earning Dividend Income, Interest Income, and Rental Income

Interest Income

• Taxpayer A earns 5% on a $100,000 investment in bonds

• Income = $100,000 x 5% = $5,000

• Tax Rate = 37% Federal + 3.8% NIIT + 8% State tax rate (assumption) = 48.8%

• Tax = $5,000 x 48.8% = 2,440

• Income After Taxes = $5,000 - $2,440 = 2,560

Dividend Income

• Taxpayer B Earns 5% on a $100,000 investment in Stocks

• Income = $100,000 x 5% = $5,000

• Tax Rate = 20% Federal + 3.8% NIIT + 8% State tax rate (assumption) = 31.8%

• Tax = $5,000 x 31.8% = 1,590

• Income After Taxes = $5,000 - $1,590 = 3,410

Rental Income

• Taxpayer C Earns 5% on a $100,000 investment in real estate (after cash expenses such as mortgage interest, real estate taxes, etc but before depreciation of $2,909*)

• Income = $100,000 x 5% - $2,909= $2,091

• Tax Rate = 37% Federal + 3.8% NIIT + 8% State tax rate (assumption) = 48.8%

• Tax = $2,091 x 48.8% = $1,020

• Income After Taxes = $5,000 - $1,020 = $3,980

I attempted to make all the different scenarios equal in investment and return to show an example. In reality, real estate will normally generate better returns compared to Interest and Dividend Income. Furthermore, there are tax laws that allow increased depreciation (out of scope of this article) that often allows taxpayers to report $0 of tax on rental income.

*Purchase of real estate requires an allocation of purchase price to building and land. Land is non-depreciable.

• For this example, we are assuming $80,000 is building and $20,000 is land

• Depreciation is therefore calculated as $80,000 / 27.5 = $2,909

Please consult your tax advisor on proper building vs land allocation.