The Schedule K-1 is a standard IRS form used to report activity related to partnership interests and is issued once a year. For investments in which you have a membership interest, the K-1 will disclose your share of any taxable items for the calendar year.
If you participate in a CrowdStreet Marketplace sale, you will typically own a membership stake in a real estate LLC (limited liability company) that is taxed as a partnership. As a result, the partnership’s taxable activity is allocated to all individual members (partners) based on ownership percentage and disclosed to investors via the K-1. The sponsor of the deal in which you have invested will issue you with a K-1.
Investors in a partnership-taxed LLC will receive a Schedule K-1, whereas REITs (real estate investment trusts) will issue a 1099 to disclose their taxable interest and/or dividends.
How many K-1s will I receive?
Any investor that invests in a Marketplace sale will obtain a single federal Schedule K-1. Investors who have made multiple investments on the Marketplace will get a federal Schedule K-1 for each investment.
Unless the real estate investment is held in a state that does not impose state income tax, you should also expect to receive a state K-1 for the state in which the property is located (also see the article “Do I need to file out-of-state tax returns and why?”).
Furthermore, if you transferred your investment from one entity to another throughout the year, you should expect to get a K-1 from each corporation that held the investment at any time during the year (i.e. two in total).
Will I still receive a K-1 even if I haven’t received a distribution yet and there is no income to report from the underlying real estate investment?
Sponsors should typically provide you with a Schedule K-1, which displays your allocable share of any real estate partnership revenue and/or loss items. If the real estate partnership’s property does not generate gross revenue or incur any amount that would be recognized as a deduction or credit for federal tax purposes, sponsors may refuse to issue a K-1. The majority of investments that fit this description are properties that are still in the planning stages. Because the building has not yet been put into service, no taxable revenue or deductible expenses have been produced during the development period.
- https://www.irs.gov/faqs/small-business-self-employed-other-business/entities/entities-4
Do REITs generate 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.
Why you shouldn’t invest in REITs?
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.
How do I report a REIT income?
To record a REIT’s income, gains, losses, deductions, credits, certain penalties, and calculate its income tax liability, use Form 1120-REIT, United States Income Tax Return for Real Estate Investment Trusts.
Do REITs produce income?
Most REITs follow a simple and easy-to-understand business model: the firm makes income by leasing space and collecting rent on its real estate, which is subsequently distributed to shareholders in the form of dividends. REITs must pay out at least 90% of their taxable income to shareholders, with the majority paying out 100%. Dividends are paid to shareholders, who then pay income taxes on them.
mREITs (or mortgage REITs) do not own real estate; instead, they finance it and profit from the interest on their assets.
Is a REIT tax-exempt?
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.
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.
- In the partnership structure if a fund has assets in numerous jurisdictions, there exists a tax filing obligation at the partnership level in each state where a property is held and tax must generally be withheld on behalf of nonresident partners which can be a time-consuming and costly procedure. 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 common for fund managers. K-1 delivery delays are common where fund investments are held directly or through other partnerships due to a lack of complete 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 dividends 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). Furthermore, investors have increases in personal compliance costs due 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.
Is REIT a good investment in 2021?
Three primary causes, in my opinion, are driving investor cash toward REITs.
The S&P 500 yields a pitiful 1.37 percent, which is near to its all-time low. Even corporate bonds have been bid up to the point that they now yield a poor return compared to the risk they pose.
REITs are the last resort for investors looking for a decent yield, and demographics support greater yield-seeking behavior. As people near retirement, they typically begin to desire dividend income, and the same silver tsunami that is expected to raise healthcare demand is also expected to increase dividend demand.
The REIT index’s 2.72 percent yield isn’t as high as it once was, but it’s still far better than the alternatives. A considerably greater dividend yield can be obtained by being choosy about the REITs one purchases, and higher yielding REITs have outperformed in 2021.
Do REITs do well in a recession?
It’s crucial to remember that nothing can fully protect you against a recession. Any venture has weaknesses and hazards, and each economic downturn presents new obstacles.
While no recession is the same as the last, there are some real estate sectors that are more robust during a downturn. Real estate investments that meet people’s basic requirements, such as housing and agriculture, or that provide important services for economic activity, such as data processing, wireless communications, industrial processing and storage, or medical facilities, are more likely to weather the storm.
Investors can own and manage properties in any of the asset classes, but many prefer to invest in real estate investment trusts (REITs) (REIT). REITs can be a more affordable and accessible method for investors to enter into real estate while also obtaining access to institutional-quality investments in a diversified portfolio.
Data centers
We live in a data-driven technology era. Almost everything we do now requires data storage or processing, and the demand for data centers will only grow in the next decades as more technological or data-driven gadgets are released. During recessions, more people stay at home to watch TV, use their computers or smartphones, or, in the case of the recent coronavirus outbreak, work from home, increasing the need on data centers. According to the National Association of Real Estate Investment Trusts, there are currently five data center REITs to select from, with all five up 33.73 percent year to date (NAREIT).
Self-storage
Self-storage is widely regarded as a recession-proof asset type. As budgets tighten, some families downsize, relocating to other places to better their quality of life or pursue a new work opportunity, or downsizing by moving in with each other to save money. This indicates that there is a higher need for storage.
The COVID-19 pandemic, on the other hand, has had an unforeseen influence on the storage industry. While occupancy has remained high, eviction moratoriums and increasing cleaning and safety costs have resulted in lower revenues. According to NAREIT, self-storage REITs are down 3.51 percent year to date. However, this industry is expected to recover swiftly, particularly for companies like Public Storage (NYSE: PSA), the largest publicly traded self-storage REIT, which has a strong credit rating and a diverse portfolio.
Warehouse and distribution
E-commerce has altered the way our economy works. Demand for quality warehousing and distribution centers has soared as more consumers purchase from home than ever before. Oversupply of industrial space, particularly warehouse and distribution space, is a risk, given that this sector has been steadily growing for the past decade; however, as a result of COVID-19, it has already proven to be the most resilient asset class of all commercial real estate, making it an excellent choice for a recession-resistant investment. Prologis (NYSE: PLD), one of the major warehousing and logistics REITS, and Americold Realty Trust (NYSE: COLD), a REIT that specializes in cold storage facilities, have both proven to be quite durable in the present economic situation, with plenty of space for expansion.
Residential housing
People will always require housing. Residential housing, which can range from single-family homes to high-rise flats or retirement communities, fulfills a basic need that is necessary even in difficult economic times. During economic downturns, rents may stagnate and evictions or foreclosures may increase, but residential rentals are a relatively reliable and constant source of income. Despite the COVID-19 challenges, American Homes 4 Rent (NYSE: AMH), which specializes in single-family rental housing, and Equity Residential (NYSE: EQR), which specializes in urban high-rises in high-density areas, are two of the largest players in residential housing, both of which have maintained high occupancy and collection rates.
Agriculture
Aside from housing, agriculture and food production are two additional critical services on which our country and the rest of the world rely. Our existing food system is primarily reliant on industrial agriculture, but more and more autonomous and regenerative agricultural projects are springing up, allowing for more crop diversification, increased productivity, and reduced economic and environmental risk.
Wireless communication
Wireless communication has grown into a giant sector, with American Tower (NYSE: AMT) and Crown Castle International (NYSE: CCI) being two of the world’s largest REITs. Cell tower REITs that provide telecommunication services are an important part of our world today, and while growth prospects can be difficult to come by, very good track records and rising demand make this a terrific real estate investment that will weather any economic downturn.
Medical facilities
Medical facilities, senior housing, hospitals, urgent care clinics, and surgery centers all provide a vital service that will always be in demand, even during economic downturns.
Retail centers
Before you abandon ship when you see this category, let me state unequivocally that retail is not dead, at least not in all forms. Grocery stores and other retail outlets that provide critical services and products will continue to be in demand, as they did during the last pandemic. The issue here is for retail REITs to invest in the vital service sector with such focus that other sectors such as tourism, restaurants, or general shopping and goods do not put the company or investment at risk.
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.
How do REITs avoid taxes?
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.
Do REITs pass through losses?
Finally, a real estate investment trust (REIT) is not a pass-through corporation. This means that, unlike a partnership, a REIT is unable to pass on any tax losses to its shareholders.
