Taxable Investors: To REIT or not to REIT in a post-TCJA world
INSIGHT ARTICLE |
Real estate funds considering setting up a real estate investment trust (REIT) structure have historically had to consider several factors, including the investor mix, the cost/benefit of operating a REIT and the feasibility of maintaining REIT status (see ABCs of REITs). The enactment of the Tax Cuts and Jobs Act of 2017 (TCJA) requires fund managers to take a fresh look at the impact of a REIT structure versus a partnership structure on high net worth investors based on several changes affecting the taxation of an investment in a REIT. There are several additional considerations for tax-exempt and foreign investors, but the analysis below focuses primarily on the impact of a REIT investment on taxable investors.
New benefits of a REIT structure—post TCJA
The most significant new benefit for individual investors investing in a REIT is the applicability of the new 20% deduction on ordinary REIT dividends. While investors in a partnership structure are also able to achieve this tax benefit if the partnership meets certain thresholds of depreciable property owned or wages paid, investors will more broadly be able to benefit from this deduction from a REIT investment, especially for mortgage REITs or REITs holding property that has been fully depreciated.
The reporting of section 199A eligible REIT dividends is less complex for funds and their partners than the reporting of otherwise eligible activity from underlying partnership investments, as the REIT would not be required to analyze and disclose qualifying basis and/or wages of underlying investments. Investors that would otherwise recognize ordinary income at the maximum federal 37% tax rate would pay a 29.6% federal tax on section 199A REIT dividends, resulting in significant savings compared to prior law.
REITs are also more broadly eligible to fully deduct business interest expense by making the real property trade or business election. Safe harbors adopted in the proposed section 163(j) regulations allow REITs to make this election if a REIT holds real property, interests in partnerships holding real property, or shares in other REIT stock. Anti-abuse provisions that would prevent the applicability of the real property trade or business election in partnership structures of qualified lodging facilities or qualified health care properties leased to an affiliated entity allow an exception if the properties described above are owned in a REIT and leased to a taxable REIT subsidiary.
REIT investors have historically benefitted from simplified state income tax filing requirements compared to those directly investing in real estate assets. While under prior law individuals could deduct state income taxes paid on real estate income, that benefit is now capped at $10,000 annually with the introduction of TCJA. Investing in a REIT can be a way to reduce the state tax burden for residents of lower tax jurisdictions that have lost the ability to maximize their federal tax deduction and are unable to benefit from a credit for taxes paid to other states.
Drawbacks of a REIT structure—post TCJA
Investors in REIT stock likely characterized entity level expenses under prior law as portfolio deductions subject to the 2% floor. These expenses are no longer deductible for individual taxpayers. This means that annual expenses to operate the fund, including investor management fees, are less beneficial than under prior law. Investors holding an interest outside of a REIT structure may be more likely to receive a tax benefit for the operating expenses of the partnership. For fund managers that utilize REIT structures, it may be worth revisiting which entities in the overall structure benefit from the services covered by the management fee to determine if a reallocation of expenses is warranted. This evaluation may produce a more favorable result to the extent certain fund level fees are more appropriately booked at the REIT level where they can avoid limitation under these new rules.
Investing in rental real estate through a REIT structure has historically limited individual investors from being eligible to report losses in years where the investments are unprofitable (whereas investing in a partnership allows partners to receive an allocation of loss that may be eligible to offset other items of income). The TCJA broadened the negative impact of this difference with respect to REITs in two significant areas:
- Limitation on REITs ability to utilize net operating loss (NOL): While a partnership passes through each partner’s share of losses via a K-1, the REIT blocks losses from flowing through to its shareholders. A real estate investor holding a single investment in a partnership that has $100 of loss in year one and $100 of income in year two may be able to fully utilize the year one loss to offset the year two income, regardless of whether any cash was distributed from the partnership to the investor. If that same investment was held through a REIT, the year one loss does not pass through and the year two taxable income recognized by the REIT could result in REIT level tax and taxable dividend income to the shareholder to the extent of cash distributions made by the REIT.
REITs can only utilize 80% of post-2017 NOLs created to reduce taxable income in a given year. REITs also have annual distribution requirements that are applicable after the application of NOLs. Using the same facts as above, if the REIT chose to utilize its 2018 NOL carryforward in year two it could only utilize $80 and it would still be required to distribute $20 in cash to clear its remaining taxable income with a dividends paid deduction. If a REIT distributes $20 in year two, the shareholder would be required to recognize $20 of taxable income. If the REIT instead chose to preserve its NOL carryforward and distributed $100 in year two, all $100 would be taxable to the shareholder in year two without the year one loss available to offset.
As a result of the change in the NOL rules, REITs that have historically distributed cash to the extent of income earned during the year may consider managing cash distributions in a way that minimizes the income the shareholder will recognize. In many cases, shareholders of a REIT would benefit from receiving cash distributions in a year in which an NOL is created as opposed to a subsequent year when taxable income may be realized due to earnings and profits (E&P) rules governing REIT distributions and adjustments for NOLs.
- Limitation on a REIT’s ability to take bonus depreciation for E&P purposes: The TCJA greatly expanded the applicability of bonus depreciation and allows for 100% expensing of certain assets in the year of acquisition or renovation. A REIT can still take bonus depreciation to drive down taxable income and minimize the required distribution amount. However, REIT investors are required to recognize taxable income via distributed E&P, which requires the use of Alternative Depreciation System class lives (ineligible for bonus depreciation). This means that high net worth investors receiving an annual distribution of cash flow may receive significant taxable losses from bonus depreciation if they hold their real estate through a partnership, but could potentially have taxable income if they own their investment through a REIT to the extent the REIT distributes cash that is taxed as dividend income. While this timing difference reverses in the year the assets are sold (in the form of lower gain or larger loss), the applicability of 100% bonus depreciation further increases the variance in this timing difference (and potentially the tax rate as well).
While there are several considerations outside of recent tax legislation that may make a REIT a viable or preferred option for a real estate fund, it is important to consult with your tax advisors prior to creating a new investment structure. In addition to understanding the investor mix and residency, property location, the cost/benefit of operating a REIT, and the feasibility of maintaining REIT status, additional analysis is required to assess how those investing through a REIT are affected by the TCJA and to maximize planning opportunities in the initial structure.