I’m a fan of both stock dividends and rental property income, my two favorite sources of passive / semi-passive income. When younger and less wealthy, rental property income may be preferable. As you age and accumulate wealth, you’ll likely appreciate stock dividend income more for its simplicity.
However, stock dividend income’s main drawback is that it requires significantly more capital to generate an amount equal to rental income. Rental yields are often higher than dividend yields, making stock dividends more meaningful for wealthier individuals.
While managing a rental property requires more work than earning stock dividends, this effort can be rewarding during your journey to financial independence. Remodeling and expanding properties for greater rental income was one of my favorite activities in my 20s and 30s.
In retirement, you might even appreciate having productive tasks in managing rentals. As long as the properties aren’t too difficult to maintain, the rental income will likely be more impactful in covering life expenses than stock dividends.
In this post, I’ll argue why rental property income is superior to stock dividend income, focusing on how much an asset’s value is affected to generate the income. It’s a unique point of view I don’t see anybody tackling.
The Source Of Stock Dividend Income
Dividends are distributed from a company’s net income, which is income remaining after all expenses, including taxes, have been deducted. This means a company must first pay corporate income taxes on its earnings, and then it can distribute the remaining profits to shareholders in the form of dividends.
When a company pays a dividend, it reduces the cash on its balance sheet by the amount of the dividend payout.
A dividend isn’t free money for shareholders, nor does it come out of thin air. This idea that dividend income is “free money” is one of the biggest misconceptions in finance.
The main reason a stock doesn’t permanently decline by the value of its dividend payout is due to the expectation the company will continue paying a similar dividend going forward. If there are expectations for a decline in dividend payouts, the company’s stock price will suffer.
The Source Of Rental Property Income
Now let’s look at a rental property that generates rental income. The rent comes from the utility (shelter) the property provides. Instead of reducing a rental property’s balance sheet after every rent payment, the property’s condition gets slightly more worn over time. Eventually, the landlord will have to paint the walls, replace appliances, and so forth.
But unlike the $1:$1 decline in cash for dividends paid to shareholders, the decline in a property’s condition each month is far less than the rental income it generates. A landlord might have to paint the interior walls once every 5-10 years. Appliances might need to be replaced every 10-25 years, and so forth.
As a result, after let’s say five years of renting out the property, 70%+ of the rent can potentially be captured as “profits.” Here’s an example explaining why rental income is superior to stock dividend income.
Stock Dividend Example
You own 70% of a company valued at $1 million that pays a 2% dividend yield each year, or $20,000. The company generates $40,000 a year in net profits and retains all $40,000 of it. The company therefore has a 50% dividend payout ratio.
After five years, shareholders earn $100,000 in dividends ($20,000 X 5), and the company is left with $100,000 in cash on the balance sheet. If the company didn’t pay a dividend, it would have $200,000 in cash after five years.
This extra $100,000 in cash, if it wasn’t paid out in dividends, is real money. The company would be valued at $100,000 more if sold with the cash.
Rental Income Example
You own a $1 million rental property that has a net rental yield of 4%, or $40,000 a year. After five years, you collect $200,000 in rental income after all expenses, but before taxes.
Your tenant moves out after year five, and you spend $5,000 painting the walls and replacing some appliances. Your $200,000 in rental income declines to $195,000 in net profit. If you want to take out property taxes too, you can by $60,000. We’re now at $135,000 in net profit.
In five years, your rental property can still generate at least $40,000 a year in net rental income. But due to inflation and a strong economy, you might be able to charge 10% – 20% more in rent.
In other words, the cost to pay dividends equaled a 100% decline in equivalent cash for the company, but only a 2.5% decline in the condition of the property, which was rectified through new paint and appliances. If we include property taxes, net profits decline by about 32.5%. As a result, rental income is superior to stock dividend income.
The Changing Value Of The Company And Rental Property Is The X Factor
Although rental income is superior, another variable to consider is the change in value of the company and rental property over time. Historically, stocks tend to appreciate at slightly more than double the rate of real estate (~10% vs. ~4.5%).
As a result, from an unlevered perspective, an equal amount invested in dividend stocks should provide a larger overall profit (returns plus dividends) than an equal value invested in rental properties.
However, the math changes once you introduce leverage when buying real estate versus unleveraged stock purchases. In a bull market, with leverage, owning real estate usually creates a higher cash-on-cash return.
The reality is, comparing unleveraged stock ownership with leveraged real estate is the most common scenario. Most people buy real estate with a mortgage, while most stock investors don’t buy stocks on margin for the long term. It’s easier to acquire a $1 million property after putting 20% down than acquiring $1 million of dividend stock, even with margin.
Remember, we’re comparing dividend stocks, which tend to be more established companies with slower growth, to rental properties. Investing in growth stocks that pay no dividends is for capital appreciation, which is a different comparison.
Qualified Dividend Income Tax Treatment
Both dividend income and rental income are taxed favorable compared to W2 income. However, non-qualified dividends (also called Ordinary Dividends), is taxed as ordinary income at your marginal income tax rate.
Qualified dividend income receives preferential tax treatment in the United States. Here’s how it’s taxed:
- Tax Rates:
- 0% for individuals in the 10% and 12% ordinary income tax brackets
- 15% for most individuals in middle to upper tax brackets
- 20% for high-income taxpayers (those in the top tax bracket)
- Income Thresholds (for 2024):
- 0%: Single filers with taxable income up to $47,025; Married filing jointly up to $94,050
- 15%: Single filers with taxable income between $47,026 and $518,900; Married filing jointly between $94,051 and $583,750
- 20%: Single filers with taxable income over $518,900; Married filing jointly over $583,750
- Additional Tax:
- Net Investment Income Tax (NIIT) of 3.8% may apply to high-income taxpayers
- Qualifications: To be considered “qualified,” dividends must:
- Be paid by a U.S. company or a qualified foreign company
- Not be listed as an unqualified dividend with the IRS
- Meet certain holding period requirements
- Holding Period:
- You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date
- Reporting:
- Qualified dividends are reported on Form 1099-DIV in Box 1b
Although qualified dividend tax rates are favorable, there is double taxation. Double taxation occurs when a corporation pays taxes on its profits and then its shareholders pay personal taxes on dividends or capital gains received from the corporation.
Remember, tax laws can change, and individual circumstances vary. Always consult with a tax professional for personalized advice.
Rental Income Tax Treatment
Rental property income is taxed differently from dividend income. There is no double taxation. Here’s an overview of how rental property income is taxed in the United States:
- Income Classification: Rental income is generally considered “passive income” by the IRS.
- Tax Rate: Rental income is taxed at your ordinary income tax rate, not at the preferential qualified dividend rates.
- Reporting: Rental income and expenses are typically reported on Schedule E of Form 1040.
- Deductible Expenses: You can deduct various expenses from your rental income, including:
- Mortgage interest
- Property taxes
- Insurance
- Repairs and maintenance
- Property management fees
- Utilities (if paid by the landlord)
- Depreciation of the property
- Depreciation: You can deduct the cost of the property over its useful life (27.5 years for residential properties, 39 years for commercial).
- Net Income: Your taxable rental income is the net amount after subtracting all allowable expenses from your gross rental income.
Depreciation Example To Reduce Tax Bill
As a rental property owner, you can often pay a 0% tax rate on your rental income due to the deductible expenses plus depreciation, which is a non-cash expense. Isn’t 0% tax better than paying double tax? You bet!
Let’s say you purchase a rental property for $800,000.
Step 1: Determine the value of the building. Assume the property assessment shows that 80% of the value is for the building and 20% for the land. Building value: $800,000 × 80% = $640,000
Step 2: Calculate annual depreciation Annual depreciation = Building value ÷ 27.5 years, $800,000 ÷ 27.5 = $29,090 per year
Step 3: Deduct depreciation on your tax return. You can deduct $29,090 each year from your rental income. That’s a large tax shield.
Additional considerations:
- If you buy the property mid-year, you’ll need to pro-rate the first year’s depreciation.
- When you sell the property, you’ll need to recapture the depreciation, which means you’ll pay taxes on the amount you’ve depreciated over the years.
- Depreciation can create a paper loss on your rental property even if you’re cash-flow positive, potentially reducing your overall tax burden.
Rental Income Will More Easily Support Your Retirement
If you are a competent rental property owner, the rental income will better support your retirement. Rental yields tend to be much higher than stock dividend yields. Over time, you’ll benefit from the inflation wave by earning higher rents. Additionally, your rental property should also appreciate in value.
If you want to retire or retire early, investing in rental properties will make achieving your retirement goals easier. You’ll have to put in occasional work to find tenants and maintain your rental property. However, you’ll gladly do so in your 20s and 30s to find a way out of working forever.
Once you’ve actually retired, you might not mind dealing with your rental properties as much, given it’s nice to have something productive to do. Any work you do on your rental property will see immediate results, like landscaping, which is always gratifying.
Of course, your rental property could face catastrophic damage, wiping away profitability. But that’s why you have insurance. Companies can also face existential crises too that can wipe away shareholder value instantly.
My Rental Property And Stock Dividend Ownership Plan
I plan to keep my rental properties for as long as possible. They are our main source of passive income, allowing my wife and I to remain unemployed. However, I will not be buying any more physical properties until we relocate to Honolulu. When that time comes, in 2030 or later, I might sell one or two rental properties or my primary residence, to have enough capital to purchase a new primary residence.
In the meantime, I’m dollar-cost averaging into a private real estate fund to diversify into the heartland and generate more passive income. Ideally, I’d like to have 30% of my real estate exposure outside of San Francisco and Honolulu. I just got another passive $7,900 real estate capital distribution which was a nice surprise.
Additionally, I’ll continue to dollar-cost average into the S&P 500, which pays a ~1.6% dividend yield. I’m not focused on buying high-dividend-yielding stocks since my income exposure comes from real estate. With stocks, I’m more focused on capital appreciation.
Ultimately, my goal is to own rental properties, private real estate funds, and the S&P 500 for the next 20+ years. I’m investing not only to fund our retirement but also for my children, who currently lack the capacity to invest. I’m confident that in 20 years, our children will be grateful we decided to invest today.
Reader Questions and Suggestions
Do you think rental property income is superior to stock dividend income? If not, why? What is your ideal split between rental properties and dividend stock exposure in your investment portfolio? How, if at all, does it change over time?
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