In the real estate industry, the lifeblood of any investment project is capital. In an era when real estate investment is at an all-time high, it’s important for investment funds to be able to stand out to their potential investor pool. One such differentiator lies within a key question that most savvy investors ask of any structure: “What are the tax consequences?”
We typically see partnership structures with a preferred return for investors and a promote for sponsors, but that means there’s only so much variation a fund can provide to make their investment appealing from a tax perspective. With the abounding competition in the sector, partnerships need to start looking further outside of the box.
We see a lot of growth through the use of private Real Estate Investment Trusts, or REITs. These types of investment entities can be particularly enticing to certain investor groups because of the tax benefits they provide. It’s certainly not a new concept, but there’s been a resurgence of the use of private REITs in recent years, making this an exciting trend worth exploring.
A REIT is a type of tax entity, organized as a corporation or trust, that owns income-producing real property. They can range from single-asset entities to well-diversified portfolio entities and can hold a wide variety of property types; anything from apartment buildings to skyscrapers and everything in between.
Most REITs trade on major stock exchanges and offer a number of benefits to investors. REITs are taxed as a corporation, but are also afforded some of the benefits of a flow through entity. In their simplest tax form, a REIT functions like a hybrid of the two and provides the best of both worlds.
There are a couple of reasons that partnerships are becoming more interested in REITs:
One of the biggest downfalls of a corporation is the double taxation of earnings. Income tax is paid at the corporate level when earned and then tax is paid again on the dividends distributed to the shareholders.
REITs, however, are allowed an additional tax deduction for dividends paid to shareholders. That means to the extent the REIT pays dividends equal to taxable income, there is no tax liability at the REIT. In essence, earnings are passed through to the investors in real time and many see cash flow from their investment early on.
When the REIT makes distributions to shareholders, it has the ability to designate certain distributions as a return of capital rather than a taxable dividend, which can provide tax deferred cash flow to the investors. If the REIT does make taxable distributions, the ordinary dividends paid to the shareholders are eligible for the Qualified Business Income (QBI) deduction at the shareholder level; a deduction otherwise limited to flow-through distributions.
A wide variety of investor types can recognize benefits from investing in a REIT. The list below summarizes a few of the main advantages.
IRA and Other Tax-Exempt Investors
Individual and Trust Investors
Though there are numerous benefits of using a private REIT in your real estate structure, this entity structure is not without its pitfalls. There are multiple organizational hurdles to overcome initially, as well as ongoing compliance requirements to consider.
Having the right advisors to guide you makes all the difference. Our team of experienced real estate advisors can help you navigate a REIT opportunity.