Real estate investment trusts (REITs) are again a popular investment as they recover from the pandemic and navigate rising interest rates. But even though they qualify for a pass-through tax deduction, their tax ramifications need to be carfully considered, planners say.

Over the past several years, REITs are becoming a more attractive vehicle as an alternative to the traditional real estate partnership structure, said Arthur Khaimov, tax director in the Real Estate Group of Eisner Advisory Group in New York. “The Tax Cuts and Jobs Act (TCJA) heightened taxpayers’ interests in REITs for its tax benefits,” he said.

REITs posted record-high funds from operations (FFO) in the second quarter, according to data from the National Association of Real Estate Investment Trusts in Washington, D.C. The record high of $19.6 billion was a 9.8% jump over the first quarter, and more than 80% of  REITs reported increased FFO from a year ago.

“Clients are often inquiring whether a REIT structure is right for them. The answer to this question is often yes, but also depends on the sensitivities and composition of their investors,” Khaimov said.

REITs have a number of tax considerations. For one, REITs pay no corporate income tax if they pay at least 90% of their taxable income to shareholders as dividends.

“Most of the distribution from a REIT is taxed as ordinary income. Most of the REIT dividends do not qualify as a qualified dividend and don’t enjoy the favorable maximum tax rate of 20%,” said Terry Sylvester Charron, head of the Family Wealth Investment Advisor Group at BNY Mellon Wealth Management in Boston. “They’re taxed as ordinary income and, depending on the shareholder’s tax bracket, can be taxed up to the maximum individual income tax rate of 37%.”

“Some portion of the distribution may be taxed as long-term capital gain if the REIT sells a property that it held for over a year and distributes that income to shareholders,” Charron said. The long-term capital gain would also be classified as net investment income and subject to the 3.8% surtax.

A portion of the distribution from a REIT could also be a non-taxable return of principal (capital) “if the cash distribution exceeds the REIT’s earnings,” Charron said. “This return of capital will reduce the shareholder’s cost basis in his shares. While there’s no immediate tax effect of a return of capital, lowering the cost basis of the shares could result in higher capital gains tax when the shareholder ultimately sells his share.”

She added that the dividend would be classified as investment income possibly subject to an additional 3.8% surtax if the shareholders modified AGI exceeds $125,000 to $250,000, depending on tax-filing status. The dividend portion of the distribution may entitle the shareholder to a Sec. 199A qualified business income (QBI) tax deduction.

“Generally, the 199A deduction is 20% of the amount of the ordinary dividend,” Charron said. “There’s no cap on the deduction, no wage restriction and no need to itemize deductions to receive the 199A deduction.”

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