Don’t Lose Sight of the 20% Deduction on REIT Dividends
The 199A deduction under the Tax Cut and Jobs Act (TCJA) applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers).
Let’s take a brief refresher course on some of the attributes a business entity must have to qualify as a REIT:
The REIT’s revenues must be from passive income sources such as rent or interest;
REITs primarily own income-producing real estate (office buildings, residential complexes, retail etc.), but they can own mortgage loans as well;
They must satisfy numerous organizational tests, income tests, asset tests and distribution tests on a quarterly and annual basis;
REITs can be structured as public or private entities, and are taxed as C-Corporations;
REITs usually distribute most if not all of their net income annually, to eliminate taxable income as they are allowed a special deduction for dividends paid.
Looking a bit closer at the income tests, above, there are two that are worth pointing out here: the 75% income test where at least 75% of the REIT’s gross income each year must be generated from certain specified sources such as rents, gains from sales of real property and mortgage interest, among others. Then there is the 95% income test where at least 95% of the REIT’s gross income must be derived from specified sources including all those in the 75% category, plus certain other passive income sources, even if unrelated to real estate, such as interest, dividends and gains on sales of securities.
The more common REIT is an equity REIT that owns and operates income-producing real estate. Mortgage REITs are used to purchase high-interest rate mortgages that are secured by real estate or similar securities. Mortgage REITs have to comply with the tests cited above but they also face significant tax issues. These mortgage REIT-specific issues include loan origination and servicing income, distressed real estate mortgages and foreclosure properties, hedging transactions and phantom income.
REITs can be complex business entities that often require professional investment advisors, accountants and lawyers to fully understand. However, it is a good time for individual investors and family offices to consider adding REITs to their portfolios, in part to diversify investments into real estate and further to take advantage of the 199A deduction allowed on REIT dividends. There is quite a bit of higher-paying interest rate debt in the market, as well as distressed debt being restructured and coming due that will be repackaged and resold to qualifying mortgage REITs. Our clients at Marks Paneth – both individuals and family offices - who fit certain investment parameters may wish to speak further with their investment advisors regarding mortgage-backed and equity REITs.