The Tax Cut and Jobs Act’s qualified business income deduction offers investors in real estate investment trusts a chance to deduct the qualified business income (QBI) component, among other breaks. Because most REIT distributions are classified as qualified dividends, the trusts can provide a higher deduction than would direct ownership of real estate. Some restrictions on QBI deductions also don’t apply to REITs.
A couple of years into the TJCA, “a client considering whether to go direct into real estate or invest in a REIT may now choose the REIT because there’s a tax advantage that wasn’t there before,” said Bryan Kirk, director of financial and estate planning at Fiduciary Trust Company International in San Mateo, Calif.
“The Section 199A deduction for qualified REIT dividends, netted with qualified [publicly traded partnership] income, isn’t constrained by the income-based QBI deduction limitations,” said Mariana Moghadam, CPA with Sobel & Co. in Livingston, N.J. “Even for a high-income taxpayer, the deduction equals 20 percent.”
REITs were created some 60 years ago to enable investing in a portfolio of real estate with favorable tax treatment. One requirement for REITs to be exempt from corporate taxes is to distribute most of their taxable income to shareholders, said Brian Cordes, senior vice president and head of portfolio specialists at Cohen & Steers in New York City.
He added that this income is generated mostly from property rents and historically makes up about 60% of overall REIT distributions. (In addition to QBI, REITs generally distribute the net gains from any property sales as capital gains). These trusts generally claim investment-related non-cash expenses, such as depreciation and amortization on real estate assets, which reduces their taxable income, according to Cordes. This difference in a REIT’s distributions between net operating and taxable income is considered return of capital, he said, and any tax liability from ROC is deferred until time of sale, when it’s calculated as a capital gain.
According to the IRS, income from a REIT in a mutual fund will be considered QBI, Cordes said, adding that this deduction is available for all shareholders regardless of their income level or whether they itemize or take the standard deduction.
REITs once had a worse reputation regarding taxes—a bias that lingers even after tax reform. “Most high-net-worth clients are not aware of the additional tax benefits afforded to them for REIT investments created by the TCJA,” said Davin Carey, senior wealth advisor of Carey & Hanna Tax & Wealth Planners in Oxnard, Calif., and a representative of Avantax Investment Services.
“There isn’t an inherent tax disadvantage for REIT investments because they are required legally to distribute at least 90 percent of their income every year to investors in the form of distributions,” Carey added. “Clients don’t have as much phantom taxable income or tax drag on a REIT investment, especially if it’s owned in a taxable account.”
One big disadvantage of investing in a REIT has been that a regular qualified dividend is taxed at a lower tax rate than a REIT dividend, Moghadam said.
REITs also don’t give investors the same level of control as direct real estate investment in terms of flexibility on income flows and deductions and capital gains events, according to Kirk from Fiduciary Trust Company. “There are options in gifting real estate assets to children and grandchildren that are not possible with a REIT investment,” he added.
“The 199A deduction is certainly helpful, but I warn clients that this is not a permanent deduction in the tax law. It’s due to expire in 2025,” said Lawrence Pon, CPA/PFS/CFP at Pon & Associates in Redwood City, Calif.
Pon usually allocates about 10% towards REITs in a portfolio. “I prefer diversified REITs, which also include international REITs,” he said. You can make a lot of money in international REITS, but they can be volatile.”
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