REITs are considered as pass-through corporations for tax purposes because of this last condition. Pass-through entities include LLCs and partnerships. Consider owning a convenience store with two business partners. You will receive a proportional share of the business’s income, which you will declare as income on your individual tax return.
A REIT’s profits are not taxed at the corporate level because it is a pass-through entity. It doesn’t matter how much money the REIT makes; as long as it meets the REIT rules, it won’t have to pay any corporate taxes.
This is a significant advantage for REIT investors. Profits from the majority of dividend-paying equities are effectively taxed twice. First, the business pays corporation taxes on its profits (currently taxed at a 21 percent rate). When gains are handed out as dividends, shareholders are taxed again.
To be fair, REITs aren’t entirely free of taxes. For one thing, they continue to pay property taxes on their real estate assets. REITs may also be required to pay income taxes in certain circumstances.
How can I avoid paying tax on REITs?
REITs are already tax-advantaged investments because their profits are shielded from corporate income taxes. Because REITs are considered pass-through corporations, they must disperse the majority of their profits to shareholders.
The majority of your REIT dividends will be classified as regular income if you hold them in a conventional (taxable) brokerage account. However, it’s likely that some of your REIT dividends will fall under the IRS’s definition of qualified dividends, and that some of them would be treated as a non-taxable return of capital.
Ordinary income REIT dividends meet the requirements for the new Qualified Business Income deduction. This permits you to deduct up to 20% of your REIT payouts from your taxable income.
Holding REITs in tax-advantaged retirement accounts, such as regular or Roth IRAs, SIMPLE IRAs, SEP-IRAs, or other tax-deferred or after-tax retirement accounts, is the greatest option to avoid paying taxes on them.
You can save hundreds or thousands of dollars on your investment taxes if you follow these guidelines.
Is a REIT a tax exempt entity?
2 Despite the fact that a REIT is a taxable entity, unlike the pass-through entities commonly used for real estate funds, it is eligible for deductions for all dividends paid out and, because a REIT is required to distribute substantially all of its taxable income3, it typically owes little or no income tax.
What are the tax advantages of a REIT?
REIT shareholders’ income tax obligations might be complicated. Each distribution, or dividend payout, received by taxable account holders is made up of a mix of cash obtained by the REIT from a variety of sources and classifications, each with its own set of tax implications.
REIT dividends are frequently made up of the company’s operating earnings. As a proportional owner of the REIT firm, this profit is passed through to the shareholder as ordinary income and is taxed as nonqualified dividends at the investor’s marginal tax rate.
REIT dividends may, on occasion, comprise a portion of operational earnings that was previously tax-free due to depreciation of real estate assets. A nontaxable return of capital, often known as the ROC, is a portion of the dividend that is not taxed. While it lowers the dividend’s tax burden, it also lowers the investor’s per-share cost basis. The tax liability of current income generated by REIT dividends will not be affected by a fall in cost basis, but it will increase taxes due when the REIT shares are eventually sold. This provision may give income planning options for persons with higher taxable income in the near future, such as the potential to smooth income over numerous years.
Capital gains may make up a component of REIT dividends. This occurs when a firm makes a profit on one of its real estate properties. The length of time the REIT business had that particular asset before selling it determines whether the capital gains are considered short-term or long-term. The shareholder’s short-term capital gains liability is equal to their marginal tax rate if the asset was held for less than a year. Long-term capital gains rates apply if the REIT holds the property for more than a year; investors in the 10% or 15% tax brackets pay no long-term capital gains taxes, while those in all but the highest income group pay 15%. Long-term capital gains will be taxed at 20% for shareholders in the highest income tax level, which is now 37%.
Tax benefits of REITs
Through the end of 2025, current federal tax regulations provide for a 20% deduction on pass-through income. Individual REIT owners are allowed to deduct 20% of their taxable REIT dividend income (but not for dividends that qualify for the capital gains rates). There is no deduction limit, no minimum wage requirement, and itemized deductions are not required to enjoy this benefit. For a person in the highest tax band, this provision (qualified business income) effectively lowers the federal tax rate on ordinary REIT dividends from 37 percent to 29.6 percent.
A word on current tax reform
On April 28, the Biden administration proposed a $1.5 trillion increase in individual taxes to assist defray the costs of a huge family and economic infrastructure investment. Many of the tax plans are similar to hikes in tax rates for high-income earners that were proposed during the campaign.
Congress is currently debating infrastructure initiatives and negotiating potential legislation’s structure and text. This procedure will take up a significant portion of the closing months of 2021, and if passed, it will very certainly affect the tax rates of high-income individuals.
Closing thoughts
When looking into the world of REITs, it’s critical to grasp the potential rewards and requirements. The regulations of REIT taxes are unique, and depending on the situation, shareholders may incur different tax rates. As usual, you should seek advice from your own tax, legal, and investment professionals, as each person’s situation is unique.
Why are REITs a bad investment?
Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.
The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.
Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.
REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.
Weak Growth
REITs that are publicly listed are required to pay out 90% of their profits in dividends to shareholders right away. This leaves little money to expand the portfolio by purchasing additional properties, which is what drives appreciation.
Private REITs are a good option if you enjoy the idea of REITs but want to get more than just dividends.
No Control Over Returns or Performance
Investors in direct real estate have a lot of control over their profits. They can identify properties with high cash flow, actively promote vacant rentals to renters, properly screen all applications, and use other property management best practices.
Investors in REITs, on the other hand, can only sell their shares if they are unhappy with the company’s performance. Some private REITs won’t even be able to do that, at least for the first several years.
Yield Taxed as Regular Income
Dividends are taxed at the (higher) regular income tax rate, despite the fact that profits on investments held longer than a year are taxed at the lower capital gains tax rate.
And because REITs provide a large portion of their returns in the form of dividends, investors may face a greater tax bill than they would with more appreciation-oriented assets.
Potential for High Risk and Fees
Just because an investment is regulated by the SEC does not mean it is low-risk. Before investing, do your homework and think about all aspects of the real estate market, including property valuations, interest rates, debt, geography, and changing tax regulations.
Fees should also be factored into the due diligence process. High management and transaction fees are charged by some REITs, resulting in smaller returns to shareholders. Those fees are frequently buried in the fine print of investment offerings, so be prepared to dig through the fine print to find out what they pay themselves for property management, acquisition fees, and so on.
Where do REITs go on tax return?
Dividend payments are a frequent technique to make these transfers. Dividends can be fully PID, entirely non-PID, or a combination of the two; on a dividend-by-dividend basis, the Board will determine the most appropriate make-up. Furthermore, the Scrip Dividend Alternative’s PID/non-PID make-up may differ from that of the underlying cash dividend.
PID & non-PID dividend payments
Shareholders should be aware that PID and non-PID dividends have different tax treatment. In the hands of tax-paying shareholders, PIDs are taxable as property letting income, but they are taxed independently from any other property letting revenue they may get.
Forms for requesting withholding tax exemption on PID dividend distributions are available:
- The PID from a UK REIT is included on the tax return as Other Income for UK residents who receive tax returns.
- Dividends received from non-REIT UK companies will be regarded in the same way as dividends received from REIT UK companies. From April 6, 2016, the non-PID element of dividends received by UK resident shareholders liable to UK income tax will be entitled to the tax-free Dividend Allowance (£5,000 for 2016/17) if they are subject to UK income tax. It should be noted that the PID component of dividends is not covered by this allowance.
- Any normal dividend paid by the UK REIT is included on the tax return as a dividend from a UK firm for UK residents who receive tax returns. Your dividend voucher will list your firm shares, the dividend rate, the tax credit (for 2016 and preceding years), and the dividend payable. Add the tax credit to the total dividend payments in box 4 on page 3 (box references are for the 2018 return).
Sale of shares by UK and non-UK resident shareholders
Gains realized by non-UK residents must be disclosed to HM Revenue & Customs within 30 days of the transaction.
Gains realized by UK citizens should be recorded as usual on the tax return.
Should I have REITs in my 401k?
REITs are a great option for investing in a retirement account. The existing tax-advantaged nature of REITs can be amplified by the tax-advantaged structure of retirement funds, resulting in some tremendous long-term return potential.
Can I hold a REIT in my TFSA?
According to Royal LePage, the cost of a single-family home in Canada increased 14.1 percent year over year in the first quarter of 2021. This comes after a year of exceptional house demand, with month after month of sales and price appreciation records. Saving for a down payment on a home in Toronto might take as long as 24 years for a family with average income. The housing market in Vancouver isn’t much better, with most housing alternatives requiring a family to earn more than $150,000 per year.
Those that entered the market early and profited handsomely are now sitting on large sums of money. For the previous two decades, the average price of a home in the United States has increased by 6% every year. When you combine that rate of return with historically low interest rates and reasonable mortgages, it’s easy to see why so many seasoned landlords have amassed multi-million-dollar fortunes.
Let’s take the smart money’s advice. To get into this lucrative market, you don’t need to follow the typical route of requiring a down payment or mortgage approval. You can put your TFSA money into a Real Estate Investment Trust (REIT) (REIT). REITs are eligible to be invested in through existing or new TFSA accounts because they are registered funds. As a result, you’ll be able to invest in real estate while still contributing to your TFSA, making it a win-win situation.
REITs benefit from special tax status and are very tax efficient. Generally, you can postpone paying taxes until you sell your REIT investment, giving you more money to spend or reinvest each year.
If you’re searching for a safe, predictable, and tax-efficient monthly income, a private REIT is an excellent option.
A tax-free savings account (TFSA) is a scheme that began in 2009 and allows people aged 18 and above to put money aside tax-free for the rest of their lives. Even if you didn’t start a TFSA in 2009, you still have annual contribution room.
To put it another way, a TFSA allows you to save money without paying taxes on the growth or withdrawals from the account. However, just around half of Canadians are believed to have started a TFSA, so let’s look at the benefits.
The most major advantage of a TFSA is that any investment income earned by Canadians is not taxed. Unlike an RRSP, your savings will not only grow tax-free, but you will not be taxed on the withdrawal as well.
Another reason TFSAs are so appealing to Canadians is that your income has no bearing on your contribution limit! This is not the case with an RRSP, where the amount you can contribute each year is precisely proportional to your income.
Your contribution space will not be used up. There’s no need to fret if investors don’t use their whole TFSA contribution quota; the balance will be carried over to the next year.
Withdrawing funds from your TFSA is a breeze. This is not the case with RRSPs, where you must deal with difficulties such as withholding taxes, purchasing annuities, and opening RRIFs.
When you invest in a REIT with your TFSA, you receive exposure to the stock upside as well as leverage. In other words, purchasing these funds is similar to engaging a team of pros to buy real estate on your behalf. Given the current status of Canadian real estate, including a private REIT in your TFSA is an excellent idea for future investments.
Are REIT dividends tax free?
The SPVs pay tax on their taxable income, which is calculated after deducting all permissible expenses (including interest paid to the Reit/InvIT) from gross income from rent, transmission fees, or tolls, as well as investment income like as bank interest or mutual fund income. The usual rate of 25% plus surcharge and cess, or the concessional rate of 22% plus surcharge and cess, may apply to businesses.
The interest and dividends received from the SPVs by the Reit/InvIT are tax-free. The Reit is likewise free from paying taxes on rental revenue it would have received if it had held a property directly. Other than income derived through the SPVs, a Reit/InvIT would only pay tax on capital gains and other interest and investment income. The repayment of the principle amount of the debt advanced by the SPVs to the Reit/InvIT would not constitute an income for the Reit/InvIT at all, as it would be a payback of the principal amount of the debt advanced by the latter.
The investor is only taxed on the share of the cash flow distribution that represents the Reit/interest InvIT’s income from the SPVs (which was tax-free in the hands of the SPVs) and the Reit’s rental income (which was exempt in the hands of the Reit). Furthermore, if the SPVs have chosen a lower tax rate on their earnings, the investor will be taxed on the share of the cash flow distribution that is due to the dividend. The investment would be tax-free on all other cash flows received. In any case, the cash flow due to the SPV’s debt repayment constitutes the investor’s return of capital and is not taxed.
When looking at the various sources of revenue, interest paid by the SPVs is an allowed tax deduction for the SPV, but it is taxable in the hands of the investor, not the Reit/InvIT. The dividends paid by SPVs from tax-free profits are not taxed in the hands of the Reit/InvIT; instead, they are taxed in the hands of the investor only if the SPV has chosen to pay the concessional rate of tax on its profits. The Reit’s rental revenue is tax-free in its hands, but taxable in the hands of the investors. Most streams of income are effectively taxed at a single level, with the exception of circumstances where SPVs have paid concessional rates of tax on their profits, in which case the dividend is taxed again in the hands of investors, despite the fact that the SPV has paid tax on its profits.
This is a key advantage of a Reit/InvIT over a traditional company structure, in which the firm pays tax on its profits and the shareholders pay tax on dividends, regardless of the company’s tax rate. As a result, a Reit/InvIT can effectively provide investors with a better post-tax return than a traditional company structure.
The biggest disadvantage of a Reit/InvIT for small investors is, of course, the greater minimum investment required—
Do REITs block Ubti?
The utilization of REITs has the potential to give considerable tax benefits not only to tax-exempt and overseas investors, but also to U.S. investors, thanks to the Tax Act.
- Unrelated Business Taxable Income (“UBTI”) and Effectively Connected Income (“ECI”) with a U.S. Trade or Business are blocked by REITs.
- UBTI is taxed even for tax-exempt investors. Rental income from real estate is normally excluded from UBTI, although there is an exemption when the property is financed with debt. The UBTI tax applies to debt-financed income in most cases (an exception exists for certain qualified organizations). A REIT converts rental income into dividends that are not subject to the UBTI rules.
REITs offer tax-exempt investors an additional benefit under the Tax Act. Historically, tax-exempt investors have been permitted to balance profits and losses from UBTI activities. UBTI must now be calculated separately for each activity under the Tax Act, and losses from one activity can no longer be used to offset income from other businesses. This new rule is meaningless because a REIT eliminates UBTI.
- Rental real estate typically generates ECI revenue for foreign investors, resulting in a tax burden and reporting requirement. Rental revenue is turned into conventional REIT dividends, which are not included in as ECI for foreign investors, thanks to the REIT structure. Even with a REIT structure, foreign investors have tax obligations and filing requirements that are outside the scope of this paper.
- The Tax Act’s Section 199A permits taxpayers to deduct 20% of certain forms of eligible business income, however there are wage and/or base limitations. Dividends from REITs are likewise eligible for the 20% deduction, but they are not subject to the wage and/or basis restrictions.
For real estate debt investment funds, the Section 199A deduction for REIT distributions, for example, is a major benefit. Investors in these funds would not be eligible for the 20% deduction if they operated in partnership form since they did not have wages or a depreciable basis. Furthermore, in order for the 20% deduction to apply, the interest income would have to be earned from a U.S. trade or enterprise. The REIT structure eliminates these constraints, allowing investors to take advantage of the deduction.
- Tax filing requirements exist at the partnership level in each state where a property is held, and tax must normally be withheld on behalf of nonresident partners, which may be a time-consuming and costly process. Additionally, investors are required to submit tax returns (and pay income tax) in those states. A REIT is required to file state tax filings in the states where it owns real estate. Dividends reported to U.S. investors are normally only taxable in the investor’s resident state, obviating the need for numerous state tax filings and onerous tax withholding procedures at the investor level.
- Investor deadlines for the distribution of Schedules K-1 to investors are frequent for fund managers. K-1 delivery delays are typical where fund investments are held directly or through other partnerships due to a lack of accurate information from the underlying investments. The employment of a REIT reduces, if not completely eliminates, the probability of these delays. A REIT only distributes dividends to its shareholders (i.e., the fund partnership), and the amount of taxable distributions is determined at the start of the year. As a result, the fund partnership return, as well as investor K-1s, can be prepared and distributed far sooner than the underlying REIT tax return.
- The expense of tax preparation compliance is also an important consideration when analyzing the REIT structure. Compliance expenses for tax returns rise as the number of investors in a fund grows, as does the number of states where investments are made (and thus nonresident tax withholding). Investors’ personal compliance costs have also increased as a result of state filings. Because the only activity going to investors is dividend income, and no tax withholding is required on behalf of the investors, a REIT considerably decreases compliance expenses for partnerships. Investors may see a reduction in compliance costs as a result of reporting in fewer states.
Can REITs have Ubti?
Historically, losses from individual UBTI operations have been adjusted against income from other UBTI activities by tax-exempt companies with UBTI. As a result, only the net amount of UBTI would be taxable. A provision in the 2017 Tax Cuts and Jobs Act (“TCJA”) requires UBTI to be computed separately for each trade or activity. As a result, the previously permitted netting has been eliminated, potentially resulting in increased tax liabilities due to the inability to use losses to offset income. Final guidance on how organizations will determine if they have more than one unrelated trade or business for this purpose, or how they will specifically identify separate unrelated trades or businesses to comply with this new requirement, has not yet been released as of the date of this publication.
Tax-exempt organizations frequently attempt to avoid UBTI exposure due to the two UBTI repercussions noted earlier, tax on UBTI and tax-exempt status concerns, as well as the new netting limitation. As a result, fund sponsors should be aware of the many methods available for lowering or eliminating UBTI.
When such debt is incurred for real property, qualified entities are not required to treat acquisition indebtedness, and hence debt-financed income, as UBTI. Educational organizations, such as university endowments, certain pension trusts, and certain church retirement plans, are considered qualified organizations. However, unless certain conditions are met, such as the partnership adhering to the fractions rule, this exception does not apply to investments made through partnerships, such as real estate private equity funds. This compliance check examines the partnership’s allocations to ensure that revenue does not go to tax-exempt partners while losses go to taxable partners. More on the fractions rule can be found here.
To hold UBTI-producing investments, C corporation blockers might be added in fund designs. The impact of this structure is that UBTI will be prevented by the C company, leaving only dividends to go to tax-exempt organizations, which are not subject to UBTI. While this may help organizations avoid losing their tax-exempt status, the blocker is still subject to UBTI taxation. Additionally, additional compliance and structuring expenditures may be incurred.
REITs can also help to reduce UBTI risk. REITs, like C corporation blockers, are created to hold UBTI-producing investments. REITs, unlike C corporations, are normally not taxed on their own profits.
Dividends paid to shareholders can be deducted by REITs. UBTI does not apply to REIT dividends given to shareholders, including tax-exempt corporations. When foreign entities are also investors in real estate debt funds, however, rigorous examination is required. This is done to avoid converting portfolio interest, which is normally not subject to nonresident tax withholding, into REIT dividends, which are generally subject to withholding. Here’s a detailed look at the advantages of REITs for real estate private equity funds.
Another way to avoid UBTI is to refrain from using debt financing when income would otherwise be exempt from UBTI. UBTI affects should be reduced or perhaps eliminated when purchasing investments with cash because rentals and interest are often removed. Fund sponsors, on the other hand, regularly employ leverage to improve purchasing power; however, this alternative may be limited or completely unsuitable.
Fund sponsors may create funds with several investment entities if debt financing is required. One approach would be for REITs to hold UBTI-producing investments, while other investments would be held directly by the fund partnership. Certain investments in a fund with a qualified organization for fractions rule compliance, for example, may not be eligible for fractions rule compliance. Under the fractions rule, a sale-leaseback transaction is normally not authorized, although it would still produce UBTI for a qualified entity. All other fractional rule complying investments could be held through the main fund partnership, whereas these investments might be held in a REIT.
