In this blog, we will explore these dual facets of real estate investment trusts, how they can serve as a strong asset in your diversified portfolio, and how understanding and leveraging ROC and TCJA rate cuts can minimize your tax liabilities.
We'll also delve into the complexities and potential drawbacks of these tax benefits, to offer a well-rounded perspective.
REITs offer a unique feature: part of their distributions may be classified as a Return of Capital (ROC). While ROC can provide immediate tax advantages, it comes with its set of complexities and long-term implications that investors should consider.
When you hold REITs in taxable accounts like a standard brokerage account (as opposed to tax-deferred accounts like IRAs or 401(k)s), the dividends or distributions are usually taxed as ordinary income. However, REITs can assign a portion of these payouts as ROC, which effectively lowers the amount subject to income taxation.
According to research by JP Morgan Asset Management, ROC can reduce the taxable component of REIT distributions by an impressive 60% to 90%. This is a stark contrast to corporate bonds, where the entire distribution is treated as 100% ordinary income.
While the immediate tax reduction may seem appealing, ROC has a catch. It lowers the cost basis of your investment, which is essentially the original value of the asset for tax purposes.
When you eventually sell the REIT, the lowered cost basis will likely result in higher capital gains, subject to capital gains tax rates which may be less favorable than ordinary income tax rates, depending on your specific financial situation.
So, what can you do to mitigate the capital gains impact? One approach is active tax-loss harvesting, which involves selling other assets in your portfolio at a loss to offset the capital gains generated from selling the REIT.
Federal tax rules allow you to offset long-term capital gains with long-term capital losses, and any unused losses can be carried forward indefinitely. However, state tax laws may have different provisions, so it's important to consult with a tax professional for tailored advice.
The ROC feature might appeal to specific types of investors:
Income-focused investors: Those who prioritize income over long-term growth may find ROC advantageous for its immediate tax benefits.
Tax-Sensitive Investors: If you're keen on optimizing your tax situation, the ROC feature, combined with strategic tax-loss harvesting, could be a valuable asset in your investment toolkit.
Diversified Investors: Those who hold a diversified portfolio may find it easier to employ tax-loss harvesting strategies to mitigate the ROC's impact on capital gains.
The ROC aspect of REITs presents both opportunities and challenges. On the one hand, the tax benefits can improve short-term cash flow. On the other, the longer-term implications on capital gains require proactive management and possibly a rethink of your overall CRE investment strategy.
Given these complexities, a consultation with tax and financial advisors is often a prudent step to understand how ROC in REITs aligns with your broader financial goals.
The Tax Cuts and Jobs Act or TCJA was enacted in December 2017, providing various tax cuts and reforms—one of which specifically impacted REITs. The act allowed for a 20% qualified business income (QBI) deduction for certain types of income, including dividends from REITs.
This provision has the effect of reducing the top effective tax rate for such dividends from 39.6% to 29.6% for non-corporate taxpayers, which generally includes individuals.
Why does this matter to investors? For investing in resilient REITs, the 20% deduction can significantly enhance after-tax returns, making these investments more appealing compared to other income-generating assets that don't qualify for the deduction.
The lower tax burden can translate into higher disposable income from REIT investments, which may either be reinvested or used for other purposes. However, this advantage comes with an expiration date: the end of 2025. This could have several implications:
Once the20% rate cut expires, REIT dividends will likely be subject to the pre-TCJA rates, assuming no new legislation extends or modifies these benefits. This potential increase in the tax burden could make REITs less attractive, and investors might look for alternative investment opportunities.
The anticipated expiration of the tax benefit could create volatility in the REIT market as the deadline approaches. Investors might sell off REIT holdings to lock in gains at the lower tax rate, affecting market prices.
Knowing that the rate cut is set to expire, investors might engage in tax planning strategies to mitigate the impact. This could include reallocating assets, and perhaps moving REIT investments into tax-deferred accounts where the deduction is not applicable but other tax advantages exist.
It's important to note that tax laws are subject to change, and there may be attempts to extend the provision or enact new legislation that offers similar benefits. Therefore, keeping abreast of political developments and tax policy discussions is crucial for investors who want to make the most informed decisions.
While the TCJA's 20% rate cut for REITs investment has been beneficial for investors, the looming expiration in 2025 creates uncertainty that warrants proactive planning and regular consultation with financial experts.
Given the complexities surrounding the TCJA rate cut and its upcoming expiration, it might be wise to consult a tax advisor or financial planner. They can provide personalized advice tailored to individual financial situations and may offer strategies to best navigate the changing tax landscape.
Investing in REITs can offer more than just portfolio diversification. With a multi-faceted approach that considers tax benefits, risk factors, and long-term goals, you can extract more value from your REIT investments. Here’s a guide to knitting all these elements together for a well-rounded investment strategy.
While REITs offer unique tax advantages like Return of Capital (ROC) and benefits from the Tax Cuts and Jobs Act (TCJA), it’s crucial not to be lured solely by the tax incentives.
A solid investment is not just about tax optimization; it should also match your risk tolerance and provide strong underlying fundamentals. In essence, the ideal REIT investment offers a balance between stability and tax benefits.
How much real estate should you include in your investment portfolio? Generally, financial advisors recommend allocating 5% to 15% of your portfolio to a commercial real estate investment plan, although this figure can vary depending on individual circumstances.
For instance, investors closer to retirement may opt for a different allocation compared to those in their accumulation phase.
Don't overlook the reinvestment options for your REIT dividends. By reinvesting dividends, you leverage compound growth over time, which can significantly boost your returns.
Coupled with tax benefits like ROC and TCJA rate deductions, this can result in enhanced after-tax returns and even potentially tax-free income under the right conditions.
Many investors ponder whether to hold REITs in a taxable account or a tax-deferred account like an IRA or 401(k). While tax-deferred accounts will treat all distributions as ordinary income upon withdrawal, Roth IRAs offer tax-free withdrawals if certain conditions are met.
If both options are limited for you, the tax advantages of holding REITs in a taxable account, courtesy of ROC and TCJA rate cuts, can be compelling enough to tip the balance in favor of taxable accounts.
Taxes are an integral component of your investment strategy, but they should never overshadow other critical factors like risk tolerance and financial goals. With various types of REITs available, including publicly traded and non-traded REIT options, the landscape can be complex.
Consulting a financial professional can offer insights tailored to your situation, helping you navigate the intricate world of REIT investments effectively.
Investing in REITs demands a nuanced approach. Beyond immediate tax benefits, you must consider the investment's inherent risks and long-term implications. By marrying these different elements, you can craft a REIT investment strategy that aligns perfectly with your overall financial objectives.
