The changes to the tax law have positioned real estate investors for potential, significant new tax advantages, especially taxpayers who invest in real estate through REITs.
At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act, which introduced sweeping and transformative changes to the United States tax code.
In the time since, attentive real estate experts have identified beneficial tax advantages engineered by the law, potentially improving the economics of real estate investments for current and future investors alike.
To be exact, the tax overhaul has provided favorable changes — the opportunity for substantial deductions on taxable income — for those who invest in and receive income from real estate through Real Estate Investment Trusts (REITs) in the form of qualified REIT dividends. For some investors, these deductions can be as much as 20% of their REIT dividends’ total.
How? The lion’s share of the deductions come as a direct result of the law’s treatment of pass-through businesses, which virtually all REITs are. The bottom line: The new tax code states that qualified business income paid to owners or investors of pass-through businesses is privileged to up to a 20% deduction.
What You Need to Know About the 2018 Tax Code and How It Applies to Real Estate Investing
- In general, taxpayers who invest in real estate through REITs have the opportunity to claim a Qualified Business Income (“QBI”) deduction of up to 20% on qualifying income generated through those investments. Qualifying REIT dividends are combined with qualifying publicly traded partnership (“PTP”) income to arrive at a combined QBI amount. The deduction is generally the lesser amount of 20% of the combined QBI and an amount equal to 20% of taxable income less net capital gains. For example, assume Steven has qualifying REIT dividends of $1,000, qualifying PTP income of $2,000, taxable income of $10,000, and net capital gains of $5,000. 20% of combined their QBI ($1,000 + $2,000) is $600. 20% of their taxable income minus net capital gains ($10,000 - $5,000) is $1,000. So, Steven’s QBI deduction will be the lesser $600.
- The new law preserves 1031 like-kind exchanges for real estate transactions, which means that when a REIT sells a property and uses the obtained capital to immediately acquire another, the REIT has the opportunity to enjoy tax deferrals on those transactions.
- The new Opportunity Zone program was established. This program encourages private investments into low-income communities across the US by offering capital gains tax incentives to Opportunity Zone investors. The Opportunity Zone program comprises a combination of Opportunity Zones (the investment opportunity) and Opportunity Funds (the investment vehicle). In exchange for investing in Opportunity Zones through Opportunity Funds, investors can receive new, substantial capital gains tax incentives, including tax deferral and reduction options on the principal invested as well as the potential to eliminate taxes on any capital gains subsequently earned from Opportunity Fund investments.
- Tangentially, new limitations to the ways individuals can claim deductions for mortgage payments mean that individual homeownership appears to be much more costly for many upper-middle-class taxpayers across the country. However, the pass-through deductions for individuals of that same income tier may introduce an interesting dynamic for those same owners who choose to pursue real estate investments through REITs.
- UPDATE: In August 2018, the IRS released extensive guidance on the 2017 tax revisions, clarifying some questions about how the 20% pass-through deduction would be applied. REIT dividends continue to qualify for the 20% deduction as previously understood. However, for complete information, all taxpayers should read the guidance itself or consult their financial adviser and not treat this article as tax advice.
Tax Benefits Provided for Pass-Through Businesses — Including REITs
Few elements of the tax overhaul have received as much widespread attention as the new provisions that allow some owners and investors of pass-through entities tax benefits in the form of an up to 20% deduction of qualified business income. While many organizations and owners across industries choose to structure themselves as pass-throughs — doing so provides a way to avoid double taxation of income, as it moves from the business level to the individual level — not every pass-through business qualifies for the 20% deduction under the new code.
The new law distinguishes income generated in specific industries and by practitioners of certain trades, treating each differently. For example, owners of pass-through businesses that rely on the “reputation or skill” of their owner do not qualify for the deduction in all cases, especially for taxpayers reporting higher total income amounts. So, while a repair shop structured as a pass-through entity will qualify for the deduction, a medical practice that relies on a doctor’s specialized knowledge may not. And on top of those limitations, the deduction’s final amount is subject to rules based on how the business pays wages to employees and the amount of capital it places in depreciable assets.
Fortunately, in the case of REITs and the dividends they distribute to investors, these qualifications are satisfied in almost all cases by default, meaning a deduction will be allowed in most cases.
The principal takeaway for real estate investors — or those just learning how to invest in real estate — is this: The law appears to present these provisions for REITs as an incentive for real estate investors specifically hoping to lessen the amount they pay in tax.
Tax Benefits Available through Opportunity Funds
The Opportunity Zone program first went relatively unnoticed but has since received considerable attention as its value to both investors and low-income neighborhoods became recognized. The Opportunity Zone program was introduced to stimulate investment in the development of low-income neighborhoods across the US, which now fall into the new designation of Opportunity Zones. Qualified Opportunity Zones are census tracts generally composed of economically distressed communities that fall under certain income thresholds. Opportunity Funds offer a way to invest in the development of these Opportunity Zones through three types of assets, including real estate. By investing, investors can get access to capital gains tax benefits both immediately and over the long-term — as long as they meet timing requirements. The potential capital gains tax incentives and timing requirements include:
- Investors who transfer realized capital gains into an Opportunity Fund within 180 days of realization can defer tax payments on those gains until December 31, 2026, or until they sell the investment – whichever happens first. Using this option, investors can preserve their capital and invest it for longer periods of time than they would be able to had they paid capital gains taxes immediately upon realization of a capital gain.
- If an investor holds their investment for at least five years prior to December 31, 2026, they can reduce their capital gains tax liability on the principal invested by 10%. And, if the investment is held for at least seven years prior to December 31, 2026, tax liability can be reduced by 15% total.
- If an Opportunity Fund investment is held for at least ten years, any appreciation earned from the investment can be permanently excluded from capital gains taxation. In other words, investors can expect to owe zero capital gains taxes on any additional capital gains earned from their Opportunity Fund investments.
Ultimately, the effects of the 2018 tax law are likely to make REITs — already an appealing and easy way for investors of all kinds to add exposure to real estate — even more financially viable, with relatively little expertise or management required from the investors themselves. By making the new 20% pass-through deduction a built-in bonus for passive investors far and wide, the model may also encourage many investing novices to dip their toes in real estate.
And on top of those benefits, the capital gains tax advantages introduced through Opportunity Funds make real estate a potentially highly appealing destination for investors with substantial unrealized gains, too.
While the full implications and upshot of the tax overhaul may not be apparent for years to come, real estate investors have potential reason to celebrate — and new investors may determine that it’s finally time to diversify into the asset class, now that platforms like Fundrise have made it easier than ever to access the benefits of REITs, new vehicles like Opportunity Funds, and private market investing in general.