REIT Tax Advantages

How REIT investors can save on taxes vs traditional investments

Real estate investment trusts (REITs) are chock full of useful tax benefits that simply aren’t available to many other asset classes. Here’s a look at just a few:

The Pass-Through Deduction

Thanks to the 2017 Tax Cuts and Jobs Act, sweeping new changes to the tax code allow for a lucrative tax benefit for REIT investors: the pass-through deduction.

The pass-through deduction allows REIT investors to deduct up to 20% of their dividends. Investors in the top tax bracket can potentially see their tax bill for dividends go from 37% to 29.6%. That means that you’re saving up to $740 annually on $10,000 of REIT dividends. Here’s the simple math:

Pass-through deduction example
* Assuming highest tax bracket (37%)

Avoiding Double Taxation

REITs, like many companies, distribute earnings to investors in the form of dividends. Unlike many companies however, REIT incomes are not taxed at the corporate level. That means REITs avoid the dreaded “double-taxation” of corporate tax and personal income tax. Instead, REITs are sheltered from corporate taxes so their investors are only taxed once. This is a major reason income investors value REITs over many other dividend-paying companies.

For example: Compare a REIT, a non-REIT corporation that distributes 90% of income to investors in the form of dividends and 10% reinvested, and a non-REIT corporation that distributes 50% of income to investors and 50% reinvested. Assume the Net Taxable Income is $1 million for all three at a 21% federal corporate tax rate.

REITs are required to distribute at least 90% of income to investors through dividends and any portion of income distributed to investors is not taxable at the fund level, meaning just $21,000 is paid in federal corporate taxes compared. The dividend income non-REIT corporations pay is subject to corporate income taxes, which means less funds available to distribute to investors.

Double taxation calculation example
* The non-REIT corporation dividends paid back are dependent ratio paid to investors and reinvested. 90/10 example assumes 90% to investors, 10% reinvested and 50/50 example assumes a split. Many non-REITs distribute lower than even the 50/50 example. REITs are required to distribute at least 90/10. ** State taxes not included. *** Assuming 24% tax bracket. Tax brackets can range from lowest (10%) to highest (37%).

Depreciation

Another gift the tax code has bestowed upon real estate investors is the concept of depreciation. As it relates to REITs, depreciation basically serves as a tax deferral mechanism. The greater the amount of depreciation expense, the more likely it is that the taxable portion of the REIT dividends will decrease.

Depreciation works to effectively reclassify certain dividends from “ordinary income” to “return of capital.” Minimizing “ordinary income” dividends means minimizing the amount of dividend income that is taxed at the personal rate, while maximizing the amount of income that is taxed at a 25% rate.

The 90% Rule

Historically, REITs have been given special tax treatment as a carrot to everyday investors seeking access to a diversified portfolio of real estate without the large capital investment required to actually acquire such a portfolio. In return, the tax code holds REITs to certain standards. One such standard is the 90% rule, which requires REITs to pay out at least 90% of its earnings as dividends.

The 90% rule was created to encourage REITs to fulfill the original goal of allowing everyday investors to enjoy passive income from a diversified portfolio of real estate. The 90% rule is a check on executive management which may seek to reinvest earnings rather than distributing them directly to shareholders.

Conclusion

The U.S. government has used the tax code to encourage investors to participate in real estate gains since the creation of real estate investment trusts in 1960. As was the case in the 2017 Tax Cuts and Jobs Act, more tax benefits continue to emerge for REIT investors with each new draft of the tax code. So the next time you’re with your tax advisor, ask how investing in a REIT can get you the income you want and the tax breaks you deserve.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors.