Real estate has traditionally held up well against market swings and rising inflation. Real estate investment trusts offer a compact, tax-advantaged alternative to direct ownership, and thanks to tax reform, those advantages are better than ever.
The 2017 Tax Cuts and Jobs Act introduces several new measures affecting REIT taxation. “The new tax bill is a boon for REIT investors, but they need to be careful not to let the tax tail wag the dog,” says Blake Morris, certified financial planner at The Lloyd Group in Suwanee, Georgia. “Many investors have used tax changes to drive investment decisions, only to quickly feel the pain.”
Tax reform may also have a broader impact on some REIT sectors that could also influence performance and returns. As you shape your REIT investing strategy, think about how tax reform comes into play.
[See: 8 REIT Categories With the Wind at Their Backs.]
Pass-through income gets a big tax break. One of the central features of the tax bill is a new 20 percent deduction on pass-through income. This deduction applies to businesses that operate as pass-through entities, REITs included. “REITs are mandated to distribute at least 90 percent of their income, and REITs do not pay taxes on this distributed income,” says Austin Pickle, investment strategy analyst for Wells Fargo Investment Institute in Sarasota, Florida.
This means REITs generally don’t owe any taxes, leaving more of their earnings to be passed on in the form of dividends to investors, who are taxed on that income. As a result, “the new tax law benefits REIT shareholders more than the REITs themselves,” Pickle says.
That’s because REIT dividends are taxed at the individual shareholder’s rate, rather than the corporate rate, says Scott Crowe, chief investment strategist for CenterSquare Investment Management in Plymouth Meeting, Pennsylvania. The 20 percent pass-through deduction reduces the top tax rate on REIT dividends from 39.6 percent to 29.6 percent for a taxpayer in the highest tax bracket. And “shareholders in lower brackets would have even lower rates on the same dividends.”
Crowe points out that shareholders can deduct that 20 percent of pass-through income from REITs and other pass-through entities, even if they don’t itemize deductions on their federal tax return. This change could prove to be more significant for REIT investors than the across-the-board reductions in individual tax rates.
Additionally, REIT dividends have been excluded from the wage restriction, and “thus, don’t have a cap on what they can deduct,” says Daniel Milan, managing partner of Cornerstone Financial Services in Birmingham, Michigan. Ordinarily, the 20 percent pass-through deduction is limited to whichever is greater — 50 percent of wages paid by the business or 25 percent of wages, plus 2.5 percent of the property’s original purchase price.
These exchange benefits remain intact. While the tax bill eliminated certain tax breaks, it preserved others, including the 1031 rule. It permits REITs to exchange one investment property holding for a similar one, while deferring capital gains tax on the exchange. “REITs benefit from the 1031 exchange, as it supports transaction activity leading to better liquidity and value,” says Steve Ralff, managing director of LaSalle Investment Management Securities in New York.
[See: 7 ETFs to Profit From Recent Tax Cuts.]
The rule also allows investors to exchange real property for the equivalent in REIT shares without capital gains tax. This process requires the investor to place the property in a Delaware statutory trust first. This is a separate legal entity that the IRS has deemed eligible for 1031 exchanges.
There are some additional steps required to exchange trust shares for REIT shares, but doing so may be worth the effort to capitalize on the 20 percent pass-through deduction and similar tax breaks under the new law. Of course, you can’t defer your tax liability indefinitely, and you’ll still owe capital gains tax when you sell your REIT shares.
Tax reform may favor some REIT sectors. Under the new tax law, certain REIT sectors could fare better than others. “While a lower corporate tax rate generally does not directly benefit REIT earnings, it does benefit the earnings of REITs’ main customers — corporations,” Pickle says. This, along with tax reform’s potential stimulative effect on economic growth, may increase demand for REIT properties. Rising demand leads to higher property prices and enables REITs to raise rents. “The more cyclical REIT sectors, like hotel-lodging, industrial and office REITs, should derive more fundamental benefit from tax reform than less cyclical sectors, like health care.”
Morris cautions that underlying sector risks still apply. He gives the example of mortgage REITs, which are susceptible to interest rate increases. Additionally, REITs tied to the retail sector are facing increasing pressure because of consolidation and reduced in-store traffic as online retailers like Amazon (ticker: AMZN) account for a larger share of the retail market.
Investors should also be aware of how changes in the market might affect some real estate sectors more than others. “Our current bull market has been going strong for quite some time, despite some recent slips,” Morris says. Still, investors should consider how well a REIT’s underlying properties could withstand a bear stock market if one occurs.
In general, however, tax reform could be huge for REITs as certain personal tax benefits disappear. “It’s important to note that the new bill caps the amount of state and local taxes, otherwise known as SALT, that homeowners can deduct from their federal tax bill, which will actually increase taxes for some,” says Allen Shayanfekr, CEO and co-founder of real estate investment platform Sharestates. “At the same time, it provides an opportunity to earn more with direct investments into real estate-type products to offset that.”
Shayanfekr says updated tax breaks will spur new development and real estate investment opportunities. “There will be a stronger demand for rental properties, which helps developers and rental owners, as homebuyers might think twice before buying their first home and continue to rent.
Remember the risks. REITs are like any other investment and you should be clear on whether they match your risk tolerance and timeline for investing.
[See: 13 Ways to Take the Emotions Out of Investing.]
One of the biggest issues to keep in mind is liquidity. When investing in REITs, particularly non-traded REITs, remember that “access to your money could be limited, subjected to substantial penalties or suspended altogether,” Morris says.
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Tax Reform Is a Windfall for REIT Investors originally appeared on usnews.com
