Real Estate Investment Trusts (REITs) are promoted by many experts as investment vehicles relatively “safe” from tax rate hikes, but proposed reforms could change that status.
The Biden Administration’s plans for tax reform include closing a popular tax “loophole” related to real estate investing that has existed since 1921. When this is coupled with the administration’s plans to change how capital gains are taxed, investors with portfolios stacked heavily with real estate are paying attention.
The American Families Plan introduced earlier this year included many ambitious tax reform proposals. However, some experts pointing to the divisiveness of Congress say massive change is unlikely. Nevertheless, with all three branches of government under Democratic control, some fiscal initiatives have a chance of getting passed without a three-fifths majority vote.
Because of their unique structure, REITs may be less affected by some changes to tax rates, making them one asset class that “could potentially help minimize the adverse impact” of tax hikes. But some additional regulatory changes included in President Biden’s proposals could uniquely affect the attractiveness of REITs as an investment vehicle.
REITs: A brief review
REITs are companies that own, finance, or operate income-producing real estate assets. When President Dwight Eisenhower signed the legislation responsible for creating REITs in 1960, the concept was heralded as a way to level the investment playing field by making equity ownership available to more people.
The law creating REITs laid the foundation for their unique “pass-through” structure and tax status. The IRS defines a REIT by specific criteria, including the provision that a REIT must pay shareholders a common dividend equal to at least 90% of its otherwise taxable income. Additionally, a company needs to invest at least 75% of its assets in real estate and derive at least 75% of its income from those assets. A REIT must also have at least 100 shareholders, and no five shareholders can control a majority of its outstanding shares.
Companies that qualify as REITs are exempt from paying corporate income tax on qualifying income to the extent they distribute their taxable income as dividends. Because the dividends are not taxed at the corporate level, REITs are a tax-efficient tool for real estate income.
Many investors opt to access REITs through a REIT ETF (exchange-traded fund) or mutual fund, allowing investors to hold a “basket” of REIT stocks. Investors looking for more diversification can access the REIT market passively through the FTSE NAREIT Global REITs Index. For investors, REITs are promoted as offering higher liquidity than owning physical real estate, plus regular distributions of cash from operations without the responsibilities of operational control.
The specifics of how REIT investors own shares and collect dividends determine their tax liability. There are different tax codes depending on whether REIT dividends are collected as ordinary income, return on capital, or capital gains. For example, those who invest in REITs through a tax-advantaged retirement savings plan—such as traditional or ROTH IRAs and 401(k)s—may not have to worry much about taxes. But REITs held in taxable accounts could face substantial liabilities.
Proposed tax code changes involving REITs
When former President Trump’s 2017 Tax Cuts and Jobs Act became law, REITs slightly waned in popularity. The tax breaks that law gave all corporations—specifically, lowering the corporate tax rate from 35% to 21%—made REITs’ special tax status less competitive. But if President Biden’s plan succeeds in raising the domestic corporate tax rate to 28% and higher foreign tax rates are passed, REITs may again have a “most favored” status.
According to the Biden Treasury Department’s Green Book, the administration is advocating three changes to tax laws concerning REITs, highlighted below:
- Ending the unlimited grandfathered status of existing “stapled REITs.” REIT “stapling” is a method of joining with a subchapter C corporation and using it to qualify with the IRS to get around regulations prohibiting REITs from containing certain types of businesses. The Administration believes this exemption dating back to 1984 is being exploited. (page 118)
- Restricting “impermissible” businesses conducted by REITs and limiting a REIT’s ownership of other corporations. This proposal would “amend section 856(c)(5)(B) of the tax code to prohibit REITs from holding stock possessing more than 10 percent of the vote or value of all classes of stock of a corporation. (page 119)
- Modify treatment of closely held REITs by imposing an additional requirement for qualification. This proposal would set limits on how much stock one person can own in a REIT. (page 120)
And about that popular, century-old “loophole:” The Biden administration has proposed legislation “reining in” Section 1031, the tax code that governs like-kind exchanges.
Under the current law, real estate investors can defer capital gains taxes on a sale of real estate by using the appreciated amount to purchase a similar investment property within 180 days. The new proposal imposes a $500,000 per person annual limit ($1 million in the case of married individuals filing a joint return) on deferrals of gains. If that initiative and the current capital gains proposals become law (something many experts believe is unlikely), they are predicted to create lasting implications for the real estate industry.
An optimistic forecast
Wall Street watchers have learned from experience that real estate is an asset class that operates differently and separately from traditional markets. Historically, REITs follow their own patterns. For example, during the dot.com recession, REITs were up when stocks overall were down. This lack of synchronization makes REITs an attractive option for balancing a portfolio heavily weighted by stocks and bonds.
The return performance of REITs, on average, is highly competitive with that of the S&P 500 and other major indices over the past twenty years. Typically, a REIT’s rate of return depends upon its industry sector, and these vehicles benefit from diversification. According to Brad Case of the National Association of Real Estate Investment Trusts (NAREIT), “REITs work well in good times, but they work especially well in bad times, because they are always looking for opportunities, and they tend to anticipate.”
Retail REITs suffered during the pandemic, as did those managing commercial office space and properties in the hospitality sector. But REITs managing businesses classified as “essential” during COVID-19, including convenience stores and pharmacies, fared much better, as did REITs concentrated in industrial properties, data centers, and health services properties.
REITs are also a popular way to earn passive income. They allow investors access to the income-producing potential of real estate without the responsibilities of direct ownership. But they are complex instruments, and their tax implications can be difficult to decipher. Therefore, understanding the specifics of REIT structure and taxation rules is essential.
Regardless of what happens on Capitol Hill, many investors are taking a close look at real estate investments in preparation for different outcomes. For example, those invested in REITs may be better positioned to ride out possible inflation and some of the tax code changes advocated by the Biden administration. But all REITs are not created equal in both their potential for return and their vulnerability to aspects of tax reform.
Lindberg & Ripple features a team of experienced wealth advisors who can assist with managing the complexities of wealth planning and complying with changing regulations. We’ll help you develop and maintain a customized strategy designed to grow and preserve wealth for future generations. Contact us to learn more.