By: April Thompson
Added: 20th July 2019
REIT Tax Basics
Real Estate Investment Trusts were created in 1960 as a means of facilitating investment in commercial real estate. The fundamental benefit of structuring as a REIT is the tax-exempt nature of the entity. REITs are not subject to a corporate tax on taxable income distributed to shareholders, only on earnings retained by the company. While this fundamental element of REITs has not changed, the REIT industry and regulatory environment continue to evolve.
REIT dividends are taxed as one of three types of return:
- Ordinary Income-Ordinary income of REITs is generated through rents and debt service and distributed to shareholders as dividends. Ordinary income is taxed to a maximum tax rate of 39.6% plus 3.8% surtax, based on the taxpayer’s income tax rate.
- Capital Gains-Capital gains are generated when returns are generated via sale of assets and income is distributed via dividend to shareholders. Capital gains are subject to a maximum tax rate of 20% plus a 3.8% surtax on investment income. Income generated via taxable REIT subsidiaries are taxed as capital gains, as the income has already been taxed by the subsidiary as ordinary income.
- Return of Capital-Return of capital is a reduction in the investor’s basis and is not a taxable distribution. If the return of capital exceeds the investor’s basis in the REIT investment, the excess is taxed at the applicable capital gains rate.
The majority of REIT dividends are taxed as ordinary income, according to NAREIT. (REIT.com, 2019)
Implications of the 2017 Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act has made some significant changes to the REIT industry, including the following benefits:
- 20% Pass-Thru Income Deduction:This reduces the maximum tax rate on REIT dividends from 39.6 percent to 29.6 percent and reduces even further the tax liability of taxpayers in lower tax brackets. Additionally, the 20% pass-thru deduction includes certain limitations, i.e. 50% of wages paid by the business or 25% of wages plus 2.5% of the properties original purchase price.
- Maintained 1031 Exchange Eligibility:The 2017 Tax Cuts and Jobs Act also maintained the rule allowing REITs to defer capital gains through 1031 exchanges, which is important for a number of reasons. Most importantly it encourages REITs to engage in transactions, both dispositions and acquisitions which allow REITs to effectively manage the composition of their portfolios without being subject to a capital gains tax that could otherwise be reinvested for the benefit of shareholders. For shareholders, this is important because it ensures the REIT is able to effectively manage its portfolio. Resultantly, it also spurs and encourages commercial real estate transactions which have a ripple effect among other investors and supports a thriving commercial real estate industry.
- Transfer of Assets to REITs: The 2017 Tax Cuts and Jobs Act also created a path for investors to transfer property via Delaware statutory trust to a REIT in exchange for shares equal to the value of the property being transferred without being subject to capital gains taxes. This is beneficial to owners and developers in an industry that has historically been largely fragmented as ownership continues to consolidate and transition to public REITs and institutional owners.
- Creation of Opportunity Zones: Discussed in greater detail below, Opportunity Zones are the most significant benefit to REITs and real estate investors from the 2017 Tax Cuts and Jobs Act. Opportunity Zone investments allow investors to defer, and in some cases, eliminate capital gains on investments within designated Opportunity Zones. More than 8700 Opportunity Zones have been designated across all 50 states, Puerto Rico and Washington DC by the US Treasury Department and represent a growing subsector of REITs.
Pros and Cons of REITs Taxes
- REITs are required to pay 90% of their taxable income to shareholders and are not subject to corporate taxes on distributed income.
- Dividends paid by a REIT are generally eligible for the 20% pass-thru deduction even though the underlying income would not qualify as Qualified Business Income if earned directly by the shareholder. The 20% deduction is available to individuals, estates, and trusts for tax years beginning after 2017 and before 2026.
- Investors have the ability to manage their tax liability in relation to their individual portfolios.
- Most dividends are taxed at a more favorable 15% tax rate, while REIT dividends are taxed at a higher ordinary-income rate.
- Only income distributed to shareholders is exempt from corporate tax.
- The recent benefits enacted by the 2017 Tax Cuts and Jobs Act will expire in 2026, which will eliminate the 20% pass-thru deduction along with other benefits.
REIT Taxes for Retirement Accounts
REITs are well-suited investments for retirement accounts, particularly retirement accounts with tax advantages such as 401ks or Roth IRAs. These accounts allow investors to defer tax obligations until retirement. The combination of REITs pretax dividends and tax-advantaged retirement accounts may allow investors to defer taxes for decades potentially. Investors have the ability to earn a greater return on high yielding REIT investments as the pretax investment compounds over time.
As shown in the chart above approximately 10%-12% of REIT are classified as return of equity, which offsets the investment basis, and would not be taxable to the investor until the original investment is fully returned. This would partially offset the tax benefit of owning REIT shares in an investment. Additionally, should the investor choose to withdraw the dividends before reaching retirement age the investor would be subject to ordinary income tax plus a 10% penalty.
REIT Taxation for Non-US Investors
Foreign investors are subject to withholding tax of 30% on REIT dividends regardless of the source generating the dividend. Some foreign investors may benefit from reduced withholding obligations as a result of treaties negotiated between governments. For example, Chinese investors are subject to a 10% withholding.
Foreign investors may be able to minimize or reduce their withholding liability through the portfolio interest exception if the REIT invests in debt. Additionally, REITs structured with less than 50 percent foreign ownership may be able to further mitigate the investor’s withholding.
However, should an entity structured as a REIT fail to maintain its REIT qualification it typically defaults to a C corporation which is subject to a 21% corporate tax rate. This presents risks to foreign investors in particular who would otherwise be able to avoid US federal income tax. (KPMG, 2019)
REITs provide an effective means of facilitating investment in real estate and distributing income to shareholders. Shareholders bare the majority of the tax burden in REIT ownership. This, however, offers shareholders the ability to manage the tax liability in relation to the rest of their investment portfolio. Which, for many investors, creates an opportunity for greater balance.
Legislation and market trends have continued to provide a favorable environment for REIT growth. The continued growth in the US economy, low-interest rates and growing demand for US real estate investment via both domestic and foreign investors are expected to continue for the foreseeable future and continue the favorable environment for REITs.