What Real Estate Investors May Not Know About the New Tax Code
New changes to U.S. tax laws will have vast implications on individuals and companies, especially since the tax code has not been changed in over three decades. Investors in real estate are wondering how the Tax Cut and Jobs Act may directly impact the treatment of pass-through entities, which are common structures used in real estate investments. At RealtyMogul, we see the recently passed tax bill in 2018 as market friendly. It may have a positive impact on investors moving forward and potentially lead to more investors entering the REIT space. Here are the changes that directly impact real estate investors in REITs.
REITs are the main investments that will likely be affected by the tax bill, as pass-through entities are set to benefit greatly from the new tax law. For the first time, REIT investors will be able to claim a 20% deduction on qualified business income generated through a REIT. Investors in REITs are expected to have a reduced tax burden on taxable income generated by REIT dividends, which should impact their after-tax returns. Also, the new pass-through rules can benefit REIT dividends by dropping the top marginal tax rate. Income previously taxed at the maximum rate of 39.6% will now be taxed at a lower rate of 29.6%.
REITs are classified as pass-through entities as they do not pay corporate tax if they "pass-through" most of their earnings to the individual members of the company or partnership. By design, REITs must pay a minimum of 90% of their taxable income in the form of shareholder dividends each year. Investors in REITs can receive these earnings in the form of dividends. Currently, dividends for individuals are taxed at the regular income rate (which can be as high as 39.6%). Going forward, individuals who invest in real estate via REITs and special purpose entitles formed specifically to acquire real estate are expected to pay a reduced effective tax rate on dividends received.
Let's use an example. For instance, after the new tax bill comes into effect, an investor invests $100,000 into a REIT that hypothetically generates a 5% dividend return for that year. After year one, that investor receives $5,000 in dividends, which is fully taxable at the income rate level. Instead of paying income tax on the entire $5,000, the taxable amount will be reduced by 20% via the new tax bill, whereby an investor would have a tax obligation on just $4,000, or 80% of their total passive income under the new law. Keep in mind there are income limitations for the deductions, which are restricted to taxpayers earning above $315,000 for married couples filing jointly and $157,500 for individuals.
REITs may be an effective way for investors to access direct real estate without the hassles of property management. Some REITs seek to offer investors a diversified stream of passive income on a regular basis. While the new tax law may benefit REIT investors, the timing is uncertain as the House and Senate bills differ on whether the corporate tax decrease will go into effect in 2018 or 2019. At present moment, the full impact or implications for other types of real estate like residential or commercial properties has yet to unfold. Based on preliminary analysis, 1031 exchanges, which allow for the deferment of capital gains taxes by using such proceeds to purchase real estate, should remain largely unaffected by the tax changes. Taxation is complicated; each investor should consult a tax professional for information specific to their individual tax situation.
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This is for informational purposes only and is not intended to provide, and should not be relied on for tax legal or accounting advice. As always, investors should understand the risks associated with real estate investing and that nothing is guaranteed.