Understanding REIT Taxation

WHAT ARE THE POTENTIAL TAX BENEFITS OF INVESTING IN REAL ESTATE THROUGH A REIT?

REITs can offer potential benefits to investors, one of which is tax deferral. This tax deferral is a result of depreciation of a property or a portfolio of properties for tax purposes. The greater the amount of depreciation expense, the more likely it is that the taxable portion of distributions made by the REIT will decrease. In order to capitalize on this potential tax benefit, it is important for shareholders to understand the two classifications of distributions:

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  • ORDINARY INCOME is the portion of the shareholders’ distributions that are taxable on a 1099 DIV Form. They represent the operating profits from the REIT’s investment in real estate.
  • RETURN OF CAPITAL is the portion of distributions that are not treated as taxable income to shareholders on a 1099-DIV Form. This occurs when the REIT’s current distributions exceed its earnings.

Return of capital provides a tax deferral to shareholders since it represents the portion of distributions that are not taxed currently. When real property that has experienced a gain is sold or disposed of by the REIT, a portion of the proceeds distributed to shareholders equal to the amount of previously-taken depreciation will be subject to a 25% tax rate. This tax, however, is lower than the typical ordinary federal income tax, which currently can be as much as 39.6%.

EXAMPLE OF ASSET DEPRECIATION AND THE EFFECT ON INCOME TAX

In Scenario 1 below, if we assume a hypothetical REIT produces a fixed periodic distribution to shareholders, 100 percent of the distributions would be considered return of capital since the annual income is $0. In Scenario 2, however, the real estate investment has a positive annual income, meaning shareholder distributions would likely be split between return of capital and ordinary income.

REIT Taxation

It should be noted that, although the annual deduction of depreciation is a taxable expense, it is not necessarily a cash expense and may not reflect the actual value of a given building, which ideally is increasing each year. Most distributions in the early stages of a REIT will be return of capital, simply because the portfolio has not acquired many income-producing assets.

INVESTOR EXAMPLE

If we assume a hypothetical 80-20 tax deferral rate in Scenario 2, where 80 percent of distributions are return of capital and 20 percent are ordinary income, a shareholder distribution would look similar to the example below. You should note, however, that you will be required to reduce the tax basis of your REIT shares by the amount of all return of capital distributions received from the REIT, as the case may be, until such time as your tax basis is exhausted, at which point you will begin to recognize gain. In addition, if you sell your REIT shares before the underlying depreciated property is sold, the lowered basis will result in the recognition of a greater amount of gain from the sale of the shares, thus eliminating the tax deferral.

REIT Taxation

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For more information about REIT taxation, please contact your financial advisor, or tax consultant.

IMPORTANT INFORMATION ABOUT REITs

An investment in shares of a non-traded real estate investment trust (REIT) is subject to risks. The following is a summary of some of these risks. A more detailed description of the risks associated with this type of investment are included in a prospectus.

  • There is no public trading market for shares of non-traded REITs and there may never be one; therefore, it will be difficult to sell your shares.
  • Because non-traded REITs are typically “blind pool” offerings, stockholders will not have the opportunity to evaluate the investments that are made with the proceeds of the offerings before shares are purchased.
  • If a non-traded REIT pays distributions from sources other than the REIT’s cash flow from operations, it will have fewer funds available for the acquisition of properties, and the overall return to stockholders may be reduced. Typically, non-traded REITs may use an unlimited amount from any source to pay distributions.
  • Distribution declarations are at the sole discretion of the REIT’s board of directors and are not guaranteed.
  • If a REIT is unable to raise substantial funds, it will be limited in the number and type of investments it may make, and the value of any investment will fluctuate with the performance of the specific properties the REIT acquires.
  • A non-traded REIT’s ability to operate profitably will depend upon the ability of its advisor to efficiently manage day-to-day operations.
  • A non-traded REIT’s advisor will face conflicts of interest relating to the incentive fee structure under the REIT’s advisory agreement, which could result in actions that are not necessarily in the long-term best interests of the REIT’s stockholders.
  • Payment of substantial fees and expenses to the REIT’s advisor and its affiliates will reduce cash available for investment and distribution.
  • A non-traded REIT may not be able to sell properties at a price equal to, or greater than, the price for which it purchased such properties, which may lead to a decrease in the value of its assets.
  • Adverse economic conditions may negatively affect property values, returns and profitability.
  • Increases in interest rates could increase the amount of debt payments and adversely affect a REIT’s ability to make distributions.
  • Disruptions in the credit markets and real estate markets could have a material adverse effect on a REIT’s results of operations, financial condition and ability to pay distributions.
  • Failure to qualify as a REIT would adversely affect operations and the ability to make distributions due to additional tax liabilities.
  • You may have tax liability on distributions you elect to reinvest in the REIT’s common stock.
  • Special considerations apply to employee benefit plans, IRAs, or other tax favored benefit accounts investing in non-traded REITs.
  • Some non-traded REITs have limited prior operating history or established financing sources.

THIS IS NEITHER AN OFFER TO SELL NOR A SOLICITATION OF AN OFFER TO BUY ANY SECURITIES. AN OFFERING IS MADE ONLY BY A PROSPECTUS. A COPY OF A PROSPECTUS MUST BE MADE AVAILABLE TO YOU IN CONNECTION WITH AN OFFERING.