After months of speculation about how a conservative government would overhaul the United States’ tax code, President Trump has signed into effect sweeping and transformative changes to the law of the land — and attentive real estate investors have identified opportunities that appear to be tailored specifically for them.
Individuals’ political opinions of and expectations for the law cover a wide spectrum, but there are several factors of the new code that are simply true and clear: as of 12:00 AM on January 1, 2018, the long-theorized revisions became reality; and the law’s provisions provide specific, extensive deductions for individuals who invest in real estate, especially those who do so through Real Estate Investment Trusts (REITs).
The lion’s share of these real estate investing deductions come as a direct result of the law’s treatment of pass-through businesses, which virtually all REITs are. The new tax code states that qualified business income paid to owners or investors of pass-through businesses is privileged to a 20% deduction. That means, for example, that income previously taxed at the maximum 37% rate will now be taxed at the significantly lower rate of 29.6%.
What You Need to Know About the New Tax Code and How It Applies to Real Estate Investing
- In general, taxpayers who invest in real estate through REITs have the opportunity for a 20% deduction of the income generated through those investments, due to REITs’ classification as pass-through entities.
- Limitations on that 20% are imposed as the full amount a taxpayer files increases from $315,000 to $415,000 for joint-filing Americans; and from $157,000 to $207,500 for single filers.
- For REIT managers, there are further advantages that give REITs the opportunities for tax deductions. For example, the new law preserves 1031 like-kind exchanges, which means that when a REIT sells a property and uses the obtained capital to immediately acquire another, those transactions enjoy tax reductions.
- New limitations to the ways individuals can claim deductions for mortgage payments means 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.
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 a 20% deduction of qualified business income. While many organizations and owners across industries choose to structure themselves as pass-throughs — 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. For example, while engineering firms do appear to qualify for the 20%, medical practices do not. And on top of those limitations, the pass-through business must also fulfill stringent requirements for how it pays wages to employees and the amount of capital it places in depreciable assets… But, happily, in the case of REITs, those qualifications are satisfied in almost all cases, by default.
The principle takeaway for real estate investors or those just now learning how to invest in real estate is this: the new tax law’s specific criteria carve out a space for which REITs are a perfect fit. 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.
There are, however, further limitations on how much of the tax deduction investors can take, based on the overall amount of income they report. Middle-class REIT investors are one of the groups receiving the largest opportunity for new tax deductions of any group addressed in the law:
- REIT investors who file joint-income less than $315,000 will be able to enjoy the full 20% deduction on qualified business income. The size of that deduction will then decrease as total income rises, up to a maximum of $415,000 of joint income reported.
- For REIT investors with individually filed income, the deduction is in full up to $157,000, and it begins its phase-out up until $207,500.
There are several other wrinkles of the new code that may relate to real estate investing and play out in interesting ways, the full impact of which remain to be seen. For example, questions about the law’s treatment of active losses remain murky until we see further clarification from the IRS. Also, early reports have projected that individual homeowners with high mortgages will actually find themselves paying higher taxes — significantly higher, perhaps. Due to the law’s new limitation on deductions taken for mortgage interest payments and deductions taken for local and/or state taxes, individuals with outsized mortgage interest payments will likely find themselves with more tax owed for 2018 than in earlier years. However, these aspects by-and-large should not be of immediate concern to passive real estate investors in their capacity of investing in REITs.
As REITs’ tax positioning improves and homeowner mortgages become less tax advantaged, it will be interesting to watch how trends shift to accommodate the model more biased by the government’s changing tax code. While, on one hand, middle-class homeowners may find that their mortgages offer fewer deductions, today’s unprecedented access to and opportunity in REIT investments may present those same taxpayers with alternatives and opportunities that even the tax law’s architects may not have fully predicted.