We partnered with Jamestown Invest to write this article. The article was originally featured on the Jamestown Invest 360 blog and can be viewed here.
While there are several considerations to adding commercial real estate investments as part of a well-balanced portfolio strategy, understanding the tax impact of investing in a Real Estate Investment Trust (“REIT”) may benefit investors when evaluating various opportunities. Currently, Jamestown is offering Jamestown Invest 1, LLC (the “Fund”) online, direct to U.S. accredited and non-accredited investors. The Fund is structured as a REIT to acquire and manage a portfolio consisting of real estate investments in urban infill locations in the path of anticipated growth. By the end of this article, you should be able to understand a few IRS rules pertaining to REIT investments, recognize potential REIT tax benefits, and better comprehend your 1099-DIV form.
We have partnered with Moore Colson CPAs and Advisors on this article to provide an expert’s opinion on the tax benefits of REITs. Jamestown does not provide tax advice. You should consult a tax advisor before making any investment decisions.
What is a REIT?
REITs were first introduced by the U.S. Congress in 1960. Until then, commercial real estate investment was generally available only to institutional investors. Most individuals simply did not have the wherewithal or resources to make meaningful and diversified investments in the space. To remedy this inequity, Congress created the REIT structure. By investing in a REIT, individual investors were able to pool funds and make meaningful investments in commercial real estate.
You may have also heard that REITs are an administratively cumbersome vehicle, and it’s true! However, it is not without reason. To ensure that REITs achieve their legislative purpose, Congress has placed specific limitations on the structure and operation of REITs. To ensure the vehicle is a passive investor in real estate, the REIT must maintain specified levels of investment in real estate assets and derive certain levels of income from real estate and other passive vehicles. To ensure that funds are pooled by individual investors, there are specific shareholder requirements and limits on the concentration of ownership of REIT shares. REITs that adhere to these requirements are afforded favorable tax treatment (discussed in more detail below).
How Are Realized Returns Determined?
Before diving into a few tax benefits involved with investing in a REIT fund, it may be important to take a step back to explain how commercial real estate funds generate returns for investors. Realized returns for real estate are comprised of two components: operating distributions and capital gain distributions.
- Operating distributions are paid to investors (typically monthly or quarterly) from cash flow generated from the fund’s underlying real estate investments. This generally comes via net rental income or portfolio income such as interest and dividends earned inside of the REIT.
- The second component of realized returns’ potential is capital gain via the sale of real estate inside of the REIT.
How Are Realized Returns Categorized?
In order to maintain its favorable tax status, a REIT is required to distribute the majority of its taxable income to the shareholders. Distributions from REITs generally fall into one of the following categories. Each category has a distinct tax treatment.
- Dividend – taxable based on your ordinary income tax rate.
- Capital Gain – taxed at short- or long-term capital gain rate, depending on if the investment or its underlying property is held for less than or greater than 12 months.
- Return of Capital – is a return of your cash investment and is not taxed.
If you recall from our How to Invest in Real Estate with a Self-Directed IRA article, should you own a REIT in a tax-deferred account like a traditional IRA, you only pay taxes when you withdraw the money from your account.
What Are the Potential Tax Benefits of Investing in a REIT?
If the requirements outlined by the IRS are maintained, REITs are given special tax treatment. Unlike other U.S. corporations, eligible REITs structures are not subject to double taxation. REITs avoid corporate-level income tax via deductions for dividends paid to shareholders. Shareholders may then enjoy preferential U.S. tax rates on dividend distributions from the REIT.
The Tax Cuts and Jobs Act (TCJA) passed into law in 2017 further enhanced the tax efficiency of REIT investing. The TCJA provides many taxpayers a tax deduction of up to 20% for Qualified Business Income, subject to certain income thresholds. Interestingly, ordinary REIT dividends qualify as Business Income for this purpose, and REIT dividends are not subject to the income thresholds, meaning REIT investors can benefit from this provision regardless of their income!
The qualified business income deduction is the lesser of: (1) 20% of the combined qualified business income amount, or (2) an amount equal to 20% of taxable income minus the taxpayer’s net capital gain amount (if any).
The below example is a hypothetical after-tax return based upon a $10,000 investment with an annual dividend yield of 7%. In our assumption, we will use a single tax filer that has no capital gains and is in the highest 2020 Federal marginal tax bracket of 37%.
Principal Investment: $10,000
Annual REIT distribution: $700
(Less) 20% Deduction: ($140)
Taxable Profit: $560
Tax Bill BEFORE TCJA 20% Deduction: $259
Tax Bill AFTER TCJA 20% Deduction: $207
After-Tax Profit BEFORE TCJA: $441
After-Tax Profit AFTER TCJA: $493
After-Tax Yield BEFORE TCJA: 4.41%
After-Tax Yield AFTER TCJA: 4.93%
Will I Receive a Schedule K-1 or Form 1099-DIV?
Typically, at the beginning of the year, investors begin asking if they will receive a 1099 or a K-1. While a Sponsor’s Investor Relations or Tax Team can help provide this information, there are some general guidelines that you should be aware of before making your investment.
Form 1099-DIV is an Internal Revenue Service form issued by a REIT, brokerage, bank, mutual fund, or real estate fund. Form 1099-DIV is issued to persons who have been paid dividends and other distributions valued at $10 or more in money or other property. Dividend income is taxed in the state(s) of residency, regardless of the property situs.
Schedule K-1 is an Internal Revenue Service tax form issued annually for an investment in a partnership. The purpose of Schedule K-1 is to report each partner’s share of the partnership’s earning, losses, deductions, and credits. Real estate income earned through a partnership may be taxed in the state(s) the property is located. The Schedule K-1 serves a similar purpose for tax reporting as a Form 1099.
Understanding your IRS Form 1099-DIV
If you invest directly into a REIT, the REIT will issue you a 1099-DIV. When you receive your Form 1099-DIV, you’ll notice several boxes already filled out. An article recently published by TurboTax, a market leader in tax software to prepare U.S. tax returns, outlined some of the reporting boxes and their implications.
- Box 1a will report the total amount of ordinary dividends you receive.
- Box 1b reports the portion of box 1a that is considered to be qualified dividends.
- If your investment makes a capital gain distribution to you, it will be reported in box 2a.
- If any state and federal taxes were withheld from your distributions, those amounts will be reported in boxes 4 for federal withholding and 14 for state withholding.
Compliant REITs are not required to pay corporate taxes. The REIT shareholders remit tax on ordinary and capital gain dividend income at their respective tax rates. REIT investors can deduct up to 20% of ordinary dividends before income tax is assessed.
A benefit of investing in a fund with exposure to multiple properties is built-in diversification without the headache of multiple state income tax filings. The investors will pay state taxes on their dividends and capital gains only in their individual state(s) of residency, compared to investing into several individual properties via partnerships.
While many individuals are familiar with public REITs listed on an exchange that provide the tax advantages we’ve outlined above, leveraging some of these benefits while adding non-correlative private real estate may be a consideration for investors seeking a more diversified portfolio. For decades, many high-net-worth individuals and institutions have allocated their portfolios to alternative investments, but this investment is not yet a portfolio staple for many individuals.
Mike Pompilio, CPA, is a Partner in Moore Colson’s Tax Services Practice. Mike leads tax services for our Real Estate Practice. He brings over 20 years of technical expertise to the firm in the complex federal taxation areas of real estate, partnerships and corporation.
Jamestown Invest is one of the first direct-to-consumer platforms launched by a global real estate institution, connecting U.S. individuals directly with real estate managed by Jamestown.