American citizens and corporations are projected to enjoy a net tax benefit of approximately $1.455 trillion over the next 10 years from the new tax law, but those benefits will not be evenly distributed among taxpayers. Still, real estate investment trusts and their investors are incontestable winners.
REITs are professional firms that purchase and operate income-generating properties with capital raised from their shareholders. They are attractive to investors who want the exposure to real estate but may not have the capital or knowledge to invest in properties directly.
Most REITs are structured as pass-through entities to avoid the double taxation of income, as they “pass through” at least 90 percent of the profit and losses to their investors. Investors receive a distribution from REITs either as ordinary income on a 1099-DIV form or as a return of capital. The latter provides tax deferral to investors since the return of capital is not taxed until the properties are sold with a profit. The 25 percent tax rate on the capital gains also could be lower than the income tax rate, which tops out at 37 percent under the old tax code.
The Tax Cuts and Jobs Act blessed REIT investors with a 20 percent tax reduction on the pass-through income received. Specifically, individual REIT investors who file jointly with taxable income less than $315,000, or file individually with income less than $157,000, may enjoy a 20 percent deduction on REIT dividends as qualified business income. REIT investors with higher taxable income — up to $415,000 jointly or $207,000 individually — also may enjoy a tax deduction on a reduced scale. REIT investors facing a high marginal income tax bracket are primary beneficiaries of the tax deduction.
The TCJA’s blessing even spills over to foreign REIT investors. Under the Foreign Investment in Real Property Tax Act, foreign REIT investors formerly were subject to a 35 percent withholding on REIT distributions. Under the new tax code, they are now subject to the corporate tax rate, which tops out at 21 percent.
Not as blessed are real estate investors who choose to buy properties directly instead of invest in REIT shares. The new tax law lowered the limit on interest deduction of mortgage debt used to acquire the principal residence and a second home from $1 million to $750,000. The TCJA also imposes a $10,000 cap on the itemized deduction of state and local property taxes. Hence, direct real estate investors, especially the leveraged investors in high property tax regions, may find REITs offer better post-tax returns under the new tax code. Together with the pass-through interest deduction, the TCJA provides an excellent opportunity for REITs to attract new capital.
In addition to the new capital infusion, the TCJA brings additional benefits to REIT operation. First, the TCJA carved out an exception concerning business interest deductions for REITs. Although most corporate taxpayers can no longer deduct the net interest expense exceeding 30 percent of EBITDA, REITs are allowed to elect out of this rule change as long as they do not use the regular Modified Accelerated Cost Recovery System depreciation. The MACRS depreciation is only used by some REITs to meet their 90 percent distribution requirement. For those, the TCJA may lead to a complex planning problem. The rest of the REIT universe can opt out of the 30 percent limitation with little consequences.
Also, REITs that are formed as partnerships or LLCs benefit from the elimination of the technical termination rule. Before the TCJA, IRC § 708(b)(1) contained a “technical termination” rule that applies to any partnership if there is an exchange of 50 percent or more of the total interests of the partnership’s capital and profits within any 12-month period. The technical termination rule leads to unwanted tax impact, hence, reduces the flexibility of business operations. Thus, lifting the technical termination rule provides more flexibility to REITs.
The few negative connotations in the tax reform for REITs include the implementation of a partial limit on REITs’ net operating loss carryover. Any new net operating loss carryover can only offset at most 80 percent of taxable income. Given that typical equity REITs’ operations are not very volatile, the 80 percent limit of net operating loss carryover is unlikely to be a binding constraint for the majority of well-run REITs. Also, net operating loss carryover will no longer expire after 20 years but can be carried forward indefinitely.
Although some REITs hold diversified types of properties in their portfolios, most REITs focus on a particular property type, including offices, apartment buildings, medical facilities, hotels and retail centers. Among specialized REITs, the retail REIT sector will likely benefit the most in the wake of tax reform. Currently, retail pays the highest effective corporate tax rate of any industry, thus lowering the corporate tax rate benefits for retail more than other industries.
Besides, the tax relief to consumers increases their discretionary income, which helps the retail sector, as well as retail REITs, in the long run. The brick-and-mortar retail sector is facing considerable pressure from e-commerce. Consequently, many U.S. retail REITs have suffered a relentless decline in stock prices since mid-2016. The TCJA will alleviate some of the pressures facing retail REITs and will usher in the potential for a turnaround in 2018.
With rising interest rates and record high property prices, the REIT sector as an asset class held a defensive posture in 2017. The new tax law benefits REITs and their shareholders in many respects and will spur further investment in REITs in 2018 and in the foreseeable future.