With the passing of the Tax Cuts and Jobs Act of 2017 (TCJA), taxable and domestic investors can now reap additional benefits of investing in a REIT as well.
Tax-exempt investors are taxed on unrelated business taxable income (UBTI). If a tax-exempt investor invests in a property through a partnership structure, it would receive rental income on a K-1 and be taxed accordingly, since the income is unrelated to its tax-exempt purpose. If the property was owned by a REIT instead of a partnership, then the REIT would have rental income, but since a REIT is a corporate entity and not a pass-through entity, it would only distribute income in the form of dividends to its shareholders. Dividends from a REIT do not fall under UBTI. By investing through a REIT, the tax-exempt investor essentially converts taxable rental income into nontaxable dividends.
For a detailed discussion on UBTI: https://www.withum.com/resources/unrelated-business-taxable-income/
By investing in a REIT (similar to the UBTI concept discussed above for tax-exempt investors), a foreign investor can avoid effectively connected income from rental income received through a partnership structure. Effectively connected income is income from all sources within the US that is connected with a trade or business, including real estate activities. Effectively connected income triggers a US filing requirement for the foreign investor. REIT dividends paid to foreign investors are subject to US withholding tax at a flat rate of 30%, but, depending on the country of residence, the tax rate can be reduced or eliminated under treaty. If the REIT withholds the taxes on behalf of the investor (and any and all other US-source income is subject to similar withholding), the foreign investor will not be required to file a US income tax return.
Additionally, a foreign investor can potentially avoid FIRPTA by investing in a REIT, but only if structured properly. The Foreign Investment in Real Property Tax Act (FIRPTA) applies to the disposition of an interest in US real property by a foreign person. Gain recognized by a foreign person on the sale of a US real property interest (USRPI) is considered effectively connected income and triggers a US filing requirement for that investor. In order to mitigate the FIRPTA tax, first, the REIT has to be domestically controlled, meaning at least 50% or more owned by US persons directly or indirectly when looking through to all of the ultimate owners. Second, upon exit, the REIT shares must be sold rather than the property itself. This typically means setting up a REIT to hold a single property so when selling the REIT, shares can be sold rather than the property directly. Even if held through a domestically controlled REIT, a foreign person will be subject to FIRPTA upon sale of the property directly because the dividends passed up to the investor after the sale are considered dividends from a REIT attributable to the gain on sale of a USRPI.
On the plus side, if a foreign investor is subject to FIRPTA, the withholding tax rate on REIT capital gain distributions has decreased from 35% to 21% under the TCJA.
All types of investors can benefit by investing in a REIT when it comes to state tax filing requirements. Generally, when a property or multiple properties are owned by a partnership, each investor receives a K-1 for each state in which investee property is located and has to file a state tax return, unless a composite return is filed on each investor’s behalf and withholding tax paid. A REIT investor does not need to file multiple state returns based on where the property is located because dividends are only sourced at the state level based on the investor’s residency. The REIT files state tax returns based on certain factors such as where the property is located, but does not have state tax withholding requirements on each investor.
IRC Section 199A entitles eligible taxpayers to deduct 20 percent of qualified REIT dividends and qualified publicly traded partnership (PTP) income. The term “qualified REIT dividends” does not include capital gain dividends. Additionally, triple net lease property, when owned by a partnership, is not eligible for the QBI deduction. Since an eligible taxpayer can deduct 20 percent of its qualified REIT dividends, holding a triple net lease property in a REIT versus a partnership will allow an investor to take advantage of this deduction.
When considering investing in real estate through a REIT or partnership, investors should consider the pros and cons of each structure. Exit considerations as well as the type of real estate operations should also be considered.