Written by North Capital Administrator

A Tax Break for REITs

The Basics

 

REITs or Real Estate Investment Trusts, give investors exposure to real estate without the level of capital investment or time associated with direct investments in real estate. Investors can buy shares in REITs similarly to how they would buy shares in a company or mutual fund, either through a broker or directly from the issuer. REITs are companies whose sole business is to own and operate real estate properties. Examples of REIT-owned properties can include apartment complexes, shopping malls, retirement communities and storage facilities. REITs generally fall into three categories, equity REITs, mortgage REITs and hybrid REITs. Equity REITs invest a majority of their assets into buying, renovating, renting and managing properties. They typically generate their revenue from rental income. Mortgage REITs make various loans to real estate projects and purchase other debt-oriented real estate products. The revenue generated from these REITs is from the interest earned on mortgage loans. Hybrid REITs allocate to real estate through both debt and equity investments. The revenue is a combination of rental and interest income. 

 

According to the SEC, a company must meet each of the following requirements in order to qualify as a REIT:

 

–        Be an entity that would be taxable as a corporation if not for its REIT status;

–        Be managed by a board of directors or trustees;

–        Have shares that are fully transferable;

–        Have a minimum of 100 shareholders after its first year as a REIT;

–        Have no more than 50 percent of its shares held by five or fewer individuals during the last   half of the taxable year;

–        Invest at least 75 percent of its total assets in real estate assets and cash;

–        Derive at least 75 percent of its gross income from real estate related sources, including rents from real property and interest on mortgages financing real property;

–        Derive at least 95 percent of its gross income from such real estate sources and dividends or interest from any source; and

–        Have no more than 25 percent of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.

 

IRS Regulations require REITs to distribute at least 90 percent of profits in the form of dividends. Any dividends distributed by REITs are the taxable portion of income produced by the REIT’s investments. Typically, REITs are structured as pass-through entities to avoid the double taxation of income. Double taxation occurs when a corporation pays income tax, distributes income through dividends, and the shareholder pays taxes again. Historically, 100% of REIT dividends received by shareholders were taxed at their ordinary income tax rates. With the changes from the 2017 Tax Cuts and Jobs Act, REIT investors may benefit from additional tax deductions.

 

A Tax Break for REITs

 

The 2017 Tax Cuts and Jobs Act (Tax Cuts and Jobs Act) went into effect on January 1st, 2018 and introduced several new measures enhancing the favorable tax status of REITs. Under the new tax law, REIT investors may now be eligible to deduct 20 percent of their qualified REIT dividends from their taxable income.  Since REITs are required to pay at least 90 percent of their income as distributions, this tax deduction can directly benefit shareholders. Furthermore, REIT investors do not need to itemize deductions in order to qualify for the 20 percent deduction. For example, an investor in the top income tax bracket who would typically pay a 37% tax on their qualified REIT dividends would now only pay 29.6%. 

 

Only traditional income generated from the REIT can qualify for the 20% deduction. Capital gains generated from a sale from a REIT at the shareholder or company level do not qualify.  For example, if a REIT sold an underlying real estate property and produced a capital gain, the distribution would not be included in the 20 percent pass-through deduction. Likewise, if an investor sold REIT shares for a profit, that capital gain would not qualify either. It is also important to note, the 20 percent pass-through deduction applies to REITs only. Mutual fund dividends are not eligible for the deduction, even if the mutual fund is invested exclusively in REITs.

 

Foreign REIT tax benefits

 

The Tax Cuts and Jobs Act also changed the taxation of international businesses, including REITs with international assets. International businesses will be subject to a one-time repatriation of previously untaxed offshore income. This could impact REITs with offshore taxable REIT subsidiaries (TRSs) that have qualifying untaxed income. Any deemed repatriation income would increase the REIT’s distribution requirement – meaning investors may expect larger distributions, all else equal. It is important to note however, that REITs could choose to defer this income over an eight-year period along with the related distribution as well.

 

Evaluating the tax benefits of REITs vs. Direct Real Estate Investments

 

Investors can gain exposure to real estate in a variety of ways, two common ways are investments directly in real estate and through REITs. Historically, direct ownership of real estate offered attractive tax benefits for investors by reducing taxable income via depreciation and operating expenses. However, with the passage of The Tax Cuts and Jobs Act, REITs deserve to be re-evaluated. One benefit is that the 20 percent deduction is not constrained by the income-based qualifying business income (“QBI”) limitations faced by direct real estate ownership. Specifically, the QBI thresholds dictate that once a real estate owner’s income exceeds their applicable threshold ($315,000 for married couple’s filing joints and $157,500 for all others), deductible expenses begin phasing out. At a certain income level, REITs may be an attractive investment.

 

As an SEC-registered investment advisor, North Capital can help you determine how real estate can fit into your diversified portfolio. To learn more, please contact a licensed North Capital Advisor at (number/email) or visit www.northcapital.com/advisory

Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers should consult with a financial adviser, attorney, accountant, and other professionals who can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.

 

Citations:

 

  1. Reits Are the Big Winners from the New Tax Law

Jiakai Chen – https://www.accountingtoday.com/opinion/reits-are-the-big-winners-from-the-new-tax-reform-law

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