At Fundrise, we structure all of our investments with the goal of maximizing risk adjusted returns for our investors.
A byproduct of this is maximizing tax efficiency so that investors take home as much of their earnings as possible. One vehicle we use to achieve this is a Real Estate Investment Trust (REIT), which can potentially increase after-tax returns by avoiding double taxation. The figures and examples contained herein are for informational purposes only, and do not constitute tax advice. All individuals should consult their own tax advisors before making any investment decisions.
How are REITs Tax Efficient?
A REIT is a company that uses proceeds from the sale of shares to invest in real estate assets. The REIT then typically earns income from rent payments or interest on real estate debt. Most REITs are structured as Limited Liability Companies (LLCs) or C Corporations. If an LLC or C Corp meets several qualifications, including that it invests at least 75% of its total assets in real estate and cash and distributes a minimum of 90% of taxable income in a given year to investors, it may avoid taxation at the fund level.
In contrast, funds that do not qualify as REITs often pay about 21% in federal corporate taxes per year, and that doesn’t include the taxes on shareholder returns that are borne by individual investors. As a result of avoiding this implicit double taxation, a REIT is able to pass along more income to investors, which may translate to higher take-home returns.
Further, REITs recently became even more tax efficient under the new 2017 Tax and Jobs Cuts Act. The bill featured a new 20 percent tax deduction for pass-through entities, such as REITs. For investors in the top tax bracket, this deduction may reduce the tax rate on REIT dividends from as much as 39.6% to as little as 29.6%.1 For more information on the new tax bill and its impact on REITs, please see here.
*Since state taxes vary, the example above excludes additional state taxes, which on average add an additional 7%.
How REITs Boost Take-Home Returns: A Case Study
Let’s take a look at a hypothetical example to compare a C corp that qualifies as a REIT to a typical non-qualifying C Corp that, as a non-REIT, only distributes 50% of its income.
If the non-REIT C Corp’s net taxable income for the year is $1,000,000, it would pay approximately $210,000 in taxes for the year, based on the 21% federal corporate tax rate. The fund could then decide to reinvest or distribute the remaining $790,000. If the C Corp re-invests half of its after-tax income and distributes half to its 100 shareholders, it would have $395,000 to reinvest and another $395,000 to distribute.
This means that each of the fund’s 100 investors would receive an annual dividend of $3,950 pre-tax. Each investor’s dividend would then be taxed again at the investor’s normal tax rate. Therefore, an investor in this fund in a middle tax bracket (e.g. 24%) would pay $948 in taxes and receive $3,002 in net dividends after federal taxes. Note that it would be rare for a non-REIT to distribute even as much as 50% of its net income, and this is still less than half the after-tax dividend received by the same investor in a REIT.
In contrast, using the same example with a C corp that qualifies as a REIT, we see that the same investor receives a substantial amount more in dividends and less income overall is lost to taxes.
If a REIT’s taxable income is $1,000,000 for the year, it would be required to distribute at least $900,000 (90%) to its 100 investors, and could choose to either re-invest or distribute the remaining $100,000. Any portion of income distributed by the REIT to investors is not taxable at the fund level, so if the REIT distributes 100% of income to investors, it pays nothing in taxes on the fund level. Assuming the REIT distributes 90%, $900,000 would not be taxable, so before taxes, each investor would receive a $9,000 dividend. Assuming an investor is in the 24% tax bracket, they would pay $2,160 in federal taxes and receive a $6,840 after-tax dividend—over 50% more than if they invested the non-REIT C Corp distributing 50%.
The REIT Advantage
Although the two scenarios above are not exactly apples to apples, you can see a pronounced tax impact if the non-REIT C corp distributes 90% to its investors like a REIT would. While it is uncommon for a C Corp to distribute as much as a REIT, for comparison’s sake, if a C Corp did distribute 90% of its net income to investors, it would pay even more in taxes, and the after-tax dollars paid to investors would still be lower than that of a qualifying REIT.
While in many cases this fund would likely look to qualify as a REIT if it is distributing 90% of its income, there are several reasons that it might not qualify as a REIT - for example if the fund is not investing primarily in real estate or is owned by too few shareholders. As a result, using the same numbers from our previous example, the fund would have $711,000 to distribute, after paying 21% federal taxes at the fund level, and only $79,000 to re-invest. Each of the 100 investors would pay $1,706 in taxes, assuming all are in the 24% tax bracket, and receive an after-tax dividend of just $5,404—over $1,400 less than that received by investors in the REIT C corp.
In total, the C Corp distributing 90% of income loses $380,640 in taxes ($210,000 on the fund level and $1,706 by each of the fund’s 100 investors) — the most of each of these three funds.
The Bottom Line
Overall, it is typically beneficial for both real estate funds and their investors for the fund to declare REIT status. There may be certain exceptions — for instance, vehicles focused on investing in single-family fix-and-flip residential assets, which REITs simply cannot do. However, in most cases, structuring a real estate investment fund as a REIT will help maximize the tax efficiency of the fund and reduce the amount of dollars lost to Uncle Sam.
Again, in examining the three cases above, the REIT distributes the most to investors and loses the least in taxes compared with the other fund structures and distribution levels. Importantly, these tax savings flow through to benefit investors at the individual level, in the form of increased dividends.
At Fundrise, we take a multifaceted approach to boosting investors’ take home returns. In addition to performing rigorous due diligence and maintaining high underwriting standards, we also look for ways to optimize a fund’s tax efficiency. While individuals who invest directly in real estate often have expensive CPAs and tax attorneys to help minimize their tax bills, investing with Fundrise offers a low-effort option for anyone to invest tax efficiently in private real estate assets. At Fundrise, we have a team of world-class tax experts dedicated to structuring our instruments in a tax efficient manner that seeks to reduce the amount paid to the IRS, and maximize your take-home returns.