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 before they invest: “What are the tax consequences?”
We typically see partnership structures with a preferred return for investors and a promotion 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. This makes figuring out how to start a REIT can be an exciting financial strategy worth exploring.
What is a Private REIT?
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 to commercial retail stores, and everything in between.
Most REITs shares are listed and traded publicly 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:
- 199A tax deduction is spurring interest for real estate investors to move their properties into REITs in order to qualify for the 20% deduction.
- Foreign investments have become increasingly popular.
Diverging from a Typical Corporation
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, management 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.
What Investor Types Can Benefit?
A wide variety of investor types can recognize REIT benefits. The list below summarizes a few of the main advantages of starting a private REIT.
Foreign Investors
- REITs function like a blocker corporation in a real estate investment fund, so setting up the REIT as the investment entity reduces the number of entities needed in the structure.
- Ordinary dividends from a REIT are not subject to foreign withholding.
IRA and Other Tax-Exempt Investors
- Dividends from a REIT do not constitute Unrelated Business Taxable Income (UBTI).
Individual and Trust Investors
- Ordinary dividends are QBI deduction eligible.
- Dividends related to the sale of real property by the REIT are designated as capital gain dividends and are eligible for capital gain rates.
- Regular cash flow for investors as REITs pay out dividends to reduce their taxable income.
- Early distributions from a REIT can be classified as return of capital to the investor as opposed to being a taxable dividend.
Why Isn't Every Real Estate Entity a Private REIT?
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.
We're Here to Help
