by Max Sharkansky
Accredited investors have access to private real estate investments structured in various ways. REITs and partnerships (such as LLCs) are among the most common structures. While both structures offer advantageous access to private real estate exposure, they differ in how their taxes work—and the differences can certainly affect an investor’s take-home returns. Here we explore the key fundamentals.
|General tax framework
||Profits of the partnership “pass through” to investors, who pay taxes on their share of the profits via individual income tax returns.
||Majority of REIT dividends are taxed as ordinary income
|Can investors directly take advantage of depreciation and pass-through losses?
|State filing requirements
||May need to file multiple state returns
||Only file in state of residence
Private real estate partnerships
Many private real estate funds and syndications are structured as partnerships or limited liability companies (LLCs). The sponsor or syndicator typically acts as the general partner or managing member—taking responsibility for the day-to-day duties of buying, managing, and selling real estate assets—while the accredited investors buy stakes in the partnership as passive members or limited partners.
From a tax perspective, these partnerships are considered pass-through entities: All the profits and losses of the partnership “pass through” the business to the members or partners, who then pay taxes on their share of the profits when they file individual income tax returns. Everything is done on a pro rata basis, so a 3% limited partner will receive 3% of the partnership’s income and 3% of its expenses.
The pass-through structure enables investors to directly take advantage of depreciation. Depreciation is an income tax deduction that allows investment property owners to recover the cost of buying and improving a property over the useful life of the property, under certain conditions.
Depreciation is a big deal for real estate investors because the tax savings can be material. Say, for example, an investor’s pro rata share of a partnership’s cash return is $100,000 in a given year. If deprecation equals $60,000 that year, then the investor’s taxable income is just $40,000.
The pass-through structure of partnerships also enables investors to take advantage of excess losses. When a partnership’s losses exceed the income generated by its properties, investors can use these excess losses to shield other passive income on their tax return. Excess losses may also be carried forward to offset passive income in future tax years.
Partnerships prepare Schedule K-1 forms each partner with information about their share of income and losses. If the partnership generates income in several states, then investors generally must file tax returns and pay income taxes in those states. To ease the burden on investors, some fund managers offer a composite election.
A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing real estate. When accredited investors choose to gain real estate exposure through a REIT, they do so by purchasing shares of a company.
To qualify as a REIT, the company is required to pay out at least 90% of its taxable income to shareholders in the form of dividends. REIT dividends can be taxed at different rates, depending on the type of dividend.
The vast majority of REIT dividends are “ordinary.” These distributions are taxed as ordinary income at the investor’s marginal tax rate, up to the current maximum rate of 37%. Investors may also have to pay a separate 3.8% net investment income tax. Thanks to the 2017 Tax Cuts and Jobs Act, REIT investors may be able to deduct 20% of taxable REIT dividend income. This effectively reduces the highest applicable federal tax rate on ordinary REIT dividends to 29.6% for taxpayers in the highest bracket.
A portion of a REIT’s dividend may be eligible for reduced tax rates. Dividends resulting from the sale of underlying property may qualify as long-term capital gains and be taxed at a maximum of 20%, plus the 3.8% surtax. It’s also possible for a REIT to distribute a nontaxable return of capital. Such “return of capital” dividends aren’t taxed, but they do reduce the investor’s cost basis in the REIT investment which can create a larger taxable gain down the road.
REITs issue a Form 1099-DIV to each investor, which spells out the amount received for each type of dividend. REIT dividends are typically only taxable in the investor’s state of residence, even if the REIT owns properties in multiple states.
It’s important for accredited investors to understand the various private real estate investment structures and how their characteristics can impact tax responsibilities—and, ultimately, investment returns. Many investors feel partnerships are the better option vs. REITs, finding the ability to benefit from depreciation and losses to be worth the burden of filing multiple state returns. As always, investors should consult with experienced tax and financial advisors to determine the best option for their unique situation.