The Power of Preferential Tax Treatment in REIT Investments
Real estate investment trusts (REITs) generate income and may offer portfolio diversification, regular cash flow, capital appreciation, and long-term wealth planning strategies for investors seeking portfolio stability during turbulent economic environments.
When it comes to evaluating a REIT’s benefits, investors should understand all tax advantages. Income distributions to REIT investors receive preferential tax treatment and can be compared to other investment vehicles on an after-tax yield basis. After-tax yield takes into consideration the taxes that may be due on the distribution, and can be useful when comparing fully taxable investments to tax-advantaged investments.
Return of Capital (ROC)
REIT distributions benefit from real estate-related tax deductions for depreciation and amortization, reducing a REIT’s net taxable income but not reducing its cash. The ROC distributions may reduce the taxable portion of distributions by an estimated 60% to 90%.
Hypothetical Example
| Preferential Tax Treatment $100,000 Investment | 5% Distribution Rate |
90% ROC | 60% ROC | 0% ROC | Fully Taxable Investment |
|---|---|---|---|---|
| Yields | ||||
| After-Tax Yield | 4.85% | 4.41% | 3.52% | 3.15% |
| Equivalent Pre-Tax Yield | 7.70% | 7.00% | 5.59% | 5.00% |
| Detailed Calculations | ||||
| Annual Cash Flow (before tax) | $5,000.00 | $5,000.00 | $5,000.00 | $5,000.00 |
| Return of Capital | $(4,500.00) | $(3,000.00) | $- | $- |
| Taxable Portion | $500.00 | $2,000.00 | $5,000.00 | $5,000.00 |
| Tax Rate | 37.0% | 37.0% | 37.0% | 37.0% |
| REIT Rate Reduction | 20.0% | 20.0% | 20.0% | 0.0% |
| Tax Rate After REIT Reduction | 29.6% | 29.6% | 29.6% | 37.0% |
| Tax Payable | $(148.00) | $(592.00) | $(1,480.00) | $(1,850.00) |
| After-tax Distribution Amount | $4,852.00 | $4,408.00 | $3,520.00 | $3,150.00 |
| Effective Federal Tax Rate | 3.0% | 11.8% | 29.6% | 37.0% |
Additional REIT Advantages
A REIT is a company that owns, operates, and/or finances a portfolio of income-generating real estate. Subject to certain suitability standards, REIT investors indirectly own part of the REIT’s professionally managed real estate portfolio.
Pass-through taxation: REITs are not taxed at the corporate level if at least 90% of taxable income is distributed to shareholders. Less money taxed allows for more funds available to distribute to investors.
Distribution taxation at favorable rates: The ordinary income portion of REIT distributions is eligible for a 20% tax deduction as part of the Tax Cuts and Jobs Act of 2017.
No federal and state income tax: REITs are not required to pay federal income tax, and in many cases, state income tax. It’s important to note that all state tax scenarios are different, and investor benefits will vary from state to state.
Capital gains treatment: If a portion of a REIT’s distributions comes from long-term capital gains, they are taxed at lower rates than ordinary income. REITs can also defer capital gains taxes by executing certain tax-deferred investment strategies, such as a Section 1031 exchange.
Estate planning advantages: When REIT shares are inherited, heirs receive a step-up in basis to fair market value without having to pay taxes on the appreciation of the shares.
Understanding a REIT’s preferred tax treatment is particularly beneficial for investors seeking an attractive long-term investment strategy, as it highlights the value of REIT distribution rates, their tax advantages, and potential income
This article was originally published by Inland. You can view the original article, here.
